Flat Tax: Pros, Cons, Examples, Compared to Fair Tax

Would a Flat Tax Lower Your Tax Bill?

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The flat tax would increase the price of everyday purchases. Photo: Tetra Images/Getty Images

Definition: The flat tax is a federal income tax system that applies the same low rate across the board. Its success depends on the tax rate proposed. It must take in enough revenue to fund the federal government. Most flat tax systems also allow exemptions for those living below the poverty line. As a result, each flat tax proposal must be evaluated carefully to assess it true revenue producing potential.

Examples

In 2016, Presidential candidate Ted Cruz proposed a 10 percent flat tax.  It would raise the standard deduction to 10 percent, and the personal exemption to $4,000. For example, a family of four wouldn't pay taxes on income below $36,000. Families could still claim some existing tax credits, such as the Child Tax Credit, the Earned Income credit, and deductions for charitable contributions and mortgage interest. Anyone can save up to $25,000 tax-free in a savings account. It eliminates the estate tax, the Alternative Minimum Tax, and Obamacare taxes. Cruz eliminated the payroll tax. His plan paid for Social Security and Medicare with a Value-Added Tax. That's a 10 percent tax on imports.  

The Cruz flat tax lowered the corporate tax rate to 16 percent. Businesses could expense equipment 100 percent when they bought it. It would eliminate taxes on profits earned abroad, and companies would be taxed 10 percent on a one-time repatriation of past income.

Goods made for exports were tax-free.  Cruz would "abolish the IRS," and replace it with something smaller.  (Source: "The Simple Flat Tax Plan," TedCruz.org.  "Ted Cruz Wants to Raise Taxes on Your Grandma," Fortune, February 2, 2016.)

In 2005, Steve Forbes proposed a similar 17 percent flat tax plan in his book, Flat Tax Revolution.

Everyone received an exemption: $13,200 for adults ($17,160 for single mothers) and $4,000 for dependents. A family of four would not pay taxes if they made less than $46,000. His plan would end the estate tax and the Alternative Minimum Tax. Also, any income that was saved or invested was tax exempt. That meant no taxes on capital gains, Social Security benefits, interest, or dividends. Corporations could expense all investments, doing away with depreciation schedules. They would only pay taxes on American-made products. See Why Do We Have to Pay Taxes?

Three Pros and Cons

The biggest advantage of a flat tax is simplicity. The current U.S. tax system is so complicated that it costs taxpayers a lot just to implement it. On average, it takes 28 hours and 30 minutes to figure out what you owe. That's whether you do your taxes, or you work the hours needed to pay someone else to do the taxes. The cost in lost productivity is $200 billion. Add to that the salaries of the 97,440 IRS employees.  

The second advantage is improved fairness. The current tax system is subject to interpretation. For example, a fictional tax return given by Money magazine to 45 tax preparers resulted in 45 different tax calculations.

Even a Treasury Department study found that callers to the IRS toll-free help lines got the wrong answers 25 percent of the time. That means those with the most sophisticated tax preparers pay the least in taxes. That can increase income inequality. (Source: MISES)

All this complexity allows greater fraud and cheating. Therefore, a flat tax would make compliance higher.

The flat tax has three disadvantages. First, most proposals don't fully replace the revenue from the existing tax system. For example, federal revenue is $3.3 trillion in FY 2017. Half of that comes from income taxes. Corporate taxes only contributed 9 percent. Most flat tax proposals don't replace existing Federal revenue. That's because the rate would be too high. As a result, they increase the national deficit and debt.

Second, the flat tax must address payroll taxes that support Social Security and Medicare benefits.

That's an income tax administered by employers. If the flat tax eliminates it, then a third of Federal income is removed. The flat tax rate must increase to control the deficit. If the flat tax keeps the payroll tax, then a lot of complexity remains in preparing tax returns. 

Third, it still leaves in place all state and local taxes. That means most families and businesses must still spend nearly the same amount of time to figure out their local tax bill. And, if you read between the lines, it appears that a lot of taxes the rich pay, such as capital gains, dividends, and interest, go away. Their exemptions, like the Social Security exclusion, remain. (Source: Forbes)

Flat Tax vs. Fair Tax

The Flat Tax is an income tax. The Fair Tax is a sales tax. Both eliminate the complicated current income tax structure.  However, the fair tax would increase the cost of everyday goods and services by 23 percent. That's like double-digit inflation. It would be the worst for retirees who live on a fixed income. See more Fair Tax Pros and Cons. (Source: "The Case for Flat Taxes," The Economist, April 14, 2005. Pros and Cons of a Flat Tax, Small Business Chronicles. 9 Pros and Cons of a Flat Tax, Connect Us Fund.)