What Is a Flat Tax System?

Definition and Examples of a Flat Tax System

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A flat tax is an income tax system that applies the same tax rate to everyone regardless of income. Most flat tax systems also allow exemptions for those living below the poverty line, so each proposal for a flat tax must be evaluated carefully to assess its true revenue-producing potential.

Some states use flat tax systems, as do several countries around the world, including Russia, Latvia, and Lithuania. The system has its pros and cons.

What Is a Flat Tax System?

A flat tax is technically a consumption tax, one that's based on what people spend rather than what they earn. It's not unlike a sales tax in this respect. It begins and ends with taking in income, either earned or unearned. The "flat" rate is imposed upon money as it's coming in to a household, and there's typically no extra tax on savings or investments.

People who earn more aren't taxed at higher rates in a flat tax system or subjected to additional taxes because of their wealth.

Nine U.S. states have a flat tax income tax system as of 2020. They include:

  • Colorado
  • Illinois
  • Indiana
  • Kentucky
  • Massachusetts
  • Michigan
  • North Carolina
  • Pennsylvania
  • Utah

Rates range from a low of 3.07% in Pennsylvania up to 5.25% in North Carolina.

How Does a Flat Tax System Work?

Social Security and Medicare taxes are examples of a flat tax system that's already in place in the U.S. Employees pay 6.2% of their earnings in Social Security tax up to a wage base of $137,700 in tax year 2020. Earnings above $137,700 are exempt—the rate doesn't increase.

Employees also pay 1.45% of their earnings to Medicare, regardless of how much they earn.

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

Politicians and executives have proposed flat tax systems at the federal level over the years. Then-presidential candidate Ted Cruz proposed a 10% flat tax rate in 2016. His proposal raised the standard deduction to 10% and the personal exemption to $4,000. It lowered the corporate tax rate to 16%.

This type of flat tax system would allow a family of four with income below $36,000 to be totally exempt from paying taxes, and many felt that was a good thing. Families could still claim some existing tax credits, as well as deductions for charitable contributions and mortgage interest.

Cruz's proposal also eliminated the estate tax, the alternative minimum tax, payroll taxes, and the Obamacare tax.

The flat income tax philosophy removes double taxation by taxing only earned income. Dividends, interest on savings, and capital gains that result from investment or increases in asset value are not taxed. This is intended to encourage investment.

This type of system simplifies the tax code, making compliance easier. The 2020 U.S. tax system is complicated and it can cost taxpayers a lot to implement it. The simplicity of a flat tax could potentially improve compliance.

Another advantage is improved fairness. The 2020 tax system is subject to interpretation. Those with the most sophisticated tax preparers often pay the least in taxes and that can increase income inequality

Reducing the top income tax rate by moving to a lower flat tax rate is thought to attract and encourage business investment at the state level, and to bring in high-income individuals, increasing overall tax revenue and economic stability.

But revenue could be lost with a flat tax system. Federal revenue was $3.5 trillion in fiscal year 2019, and half of that came from personal income taxes.  If a flat-rate tax system tried to replace that revenue, the rate would end up being too high. As a result, the national deficit and debt could increase instead.

There's also the issue of payroll taxes which are income tax-administered by employers. A third of federal income could be removed if the flat tax eliminates these taxes. The flat tax rate would need to increase to control the deficit. There'd still be a lot of complexity in preparing tax returns if the flat tax kept the payroll tax.

Moving to a flat tax system could put a burden on those who are most affected by taxation and the least able to pay, such as senior citizens.

There's also the issue that a flat tax would eliminate taxes that wealthier individuals tend to pay, such as capital gains, dividends, and interest. This could shift the tax burden to the lower and middle classes by removing deductions and expanding the tax base to include every level of income.

Some flat tax systems in the United 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 applies one percentage rate to all taxpayers regardless of income.
  • Nine states impose a flat tax, but the federal government operates on a progressive income tax system where tax rates increase along with earnings.
  • Social Security and Medicare are examples of a flat tax.
  • A flat tax system is said to be much simpler but it could cost governments revenue. 

Article Sources

  1. European Central Bank. "Flat Taxes in Central and Eastern Europe." Accessed June 22, 2020. 

  2. Tax Foundation.org. "What Are Flat Taxes?" Accessed June 25, 2020.

  3. Federation of Tax Administrators. "State Individual Income Taxes." Accessed June 22, 2020. 

  4. IRS. "Topic No. 751 Social Security and Medicare Withholding Rates." Accessed June 22, 2020. 

  5. Tax Policy Center. "An Analysis of Ted Cruz's Tax Plan," Pages 2-3. Accessed June 22, 2020. 

  6. Congressional Budget Office. "Monthly Budget Review: Summary for Fiscal Year 2019." Accessed June 25, 2020.

  7. Congressional Budget Office. "Revenues in 2017: An Infographic." Accessed June 22, 2020.