What Is a Flat Tax System?

A Flat Tax System Explained in Less Than 5 Minutes

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A flat tax is a system that levies the same fixed percentage rate on every citizen regardless of their income. Most flat tax systems exempt those living below the poverty line.

Some U.S. states use a flat tax system, as do several nations, including Russia, Latvia, and Lithuania. The U.S. federal government uses a progressive income tax system, in which the percentage of taxes owed increases with the income of the taxpayer.

Both methods have their pros and cons.

Definition and Example of a Flat Tax System

A flat tax system requires all taxpayers to remit the same percentage rate, no matter how much they earn.

A sales tax is an example of a flat tax. The tax is a fixed percentage of the product or service sold. Rich or poor, everyone pays the same amount. Sales tax laws generally exempt essential goods like food from the tax to reduce the burden on the poorest consumers.

How a Flat Tax System Works

A flat income tax is notably simpler than a progressive tax. The tax is imposed on the money as it is paid into a household.

Although any number of variations are possible, a flat tax often eliminates most tax breaks like a mortgage interest deduction or a child tax credit. There are usually no additional taxes on interest, capital gains, or dividends.

Nine U.S. states have a flat tax income tax system as of 2021. They include Colorado, Illinois, Indiana, Kentucky, Massachusetts, Michigan, North Carolina, Pennsylvania, and Utah. The rates range from a low of 3.07% in Pennsylvania up to 5.25% in North Carolina.

The FICA Tax Is Flat, Too

Social Security and Medicare taxes are also examples of flat taxes. Employees pay 6.2% of their earnings in Social Security tax up to a wage cap of $142,800 as of 2021, increasing to $147,000 in tax year 2022.

This is labeled as FICA tax on employees' W-2 forms. Self-employed people pay a comparable SECA tax for themselves plus an employer's share on behalf of their employees.

Earnings above those levels are exempt. Because of the income cap, the FICA tax system is not a progressive one.

Employees also pay 1.45% of their earnings to Medicare, regardless of how much they earn. So, oddly, the Medicare portion of the FICA tax is a progressive tax, not a flat one.

Flat Tax System vs. Progressive Tax System

Flat Tax System Progressive Tax System
A flat percentage applies to all income levels. Percentages increase as income rises.
Everyone pays the same rate. Wealthier taxpayers pay higher percentages.
It often eliminates deductions and credits. Spending is rewarded through deductions.

Pros and Cons of a Flat Tax System

The flat income tax philosophy addresses an issue that its proponents call double taxation. That is, in a progressive tax system, taxes may be levied on earned income and again on dividends, interest, or capital gains that result from the investment of (post-tax) income.

A flat tax generally simplifies the tax code, making compliance easier. Critics point out that by 2020, the U.S. Tax Code comprised about 9,000 pages of regulations plus another 81,000 pages devoted to the related case law.

Another perceived advantage is improved fairness. The federal tax system is not only complex but subject to interpretation. Those with the most sophisticated tax preparers often pay the least in taxes. 

One Flat Tax Proposal

Some American politicians have advocated a flat federal tax system. One proposal came from Republican U.S. Sen. Ted Cruz, a presidential candidate in 2016. His plan would have imposed a 10% flat tax rate, raised the standard deduction to 10%, and raised the personal exemption to $4,000. It lowered the corporate tax rate to 16%.

A family of four with income below $36,000 would be exempt from taxes in this plan. Families could still claim some existing tax credits as well as deductions for charitable contributions and mortgage interest.

Proponents argue that reducing the top income tax rate by moving to a lower flat tax rate encourages business investment and attracts high-income individuals, increasing overall tax revenue and economic stability.

The Downside of a Flat Tax

Revenue could be lost with a flat tax system, depending on just how high that flat tax rate is. Federal revenue totaled $3.5 trillion in fiscal year 2019, and half of that came from personal income taxes, including taxes on capital gains, dividends, and interest. The rate could end up being higher than is politically acceptable if a flat-rate tax system tried to replace that revenue.

Opponents argue that a flat tax system would transfer the tax burden to lower-income and middle-income taxpayers.

A flat tax could also eliminate altogether some taxes that wealthier individuals tend to pay, such as capital gains, dividends, and interest income taxes.

In addition, it could greatly reduce taxes on the richest Americans. Tax rates range from 10% to 37% in 2021, depending on income.

Assuming that more commonly-used deductions are eliminated, the tax burden could shift dramatically to the lower and middle classes.

Some flat tax systems in states get around this by exempting individuals who fall below certain income levels and by offering special exemptions or tax credits for low-income taxpayers.

Key Takeaways

  • A flat tax levies the same fixed percentage rate on all taxpayers.
  • Examples of a flat tax include sales tax and Social Security and Medicare taxes.
  • The U.S. uses a progressive tax system, in which higher-income residents pay a higher percentage in income tax.