What Is a Flat Tax System?

A flat income tax system could increase your tax bill

Senior couple listening to their female financial consultant at home. Elderly couple at home meeting with financial advisor.

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A flat tax is an income tax system that applies the same low tax rate across the board. That means everyone pays the same tax rate regardless of income. Its success often depends on the tax rate proposed because it must take in enough revenue to fund the government. 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 in the U.S. use a flat tax system, as do several countries around the world including Russia, Latvia, and Lithuania.

Here's what you need to know about the flat tax system, including its pros and cons, and how it compares to a fair tax system.

States With a Flat Tax Income System

In the U.S., nine states have a flat tax income tax system in 2020. These include:

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

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

Some Federal Tax Rates Are Already Flat

Social Security and Medicare taxes are examples of a flat tax system 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 for 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.

Advantages of a Flat Tax System

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 under a pure flat tax system. This is intended to encourage investment.

It can also simplify taxation. Everyone simply pays the same tax rate. This system often eliminates deductions, tax credits, and most exemptions, which, in theory, curbs biases toward certain behaviors and activities. It also simplifies the tax code, making compliance easier. And since the current U.S. tax system is complicated and can cost taxpayers a lot just to implement it, a flat tax could be seen as a huge benefit. The simplicity of a flat tax would improve compliance, too. With all the complexity in the income tax code, fraud is not uncommon.

Another advantage is improved fairness. The current 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

A flat tax system could also encourage economic growth by avoiding a system in which earners with higher incomes are penalized for being productive and earning more money.

Some may argue that a progressive tax creates penalties for things like hard work, risk-taking, and entrepreneurship. The flat tax could help avoid this by taxing every dollar at the same rate.

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.

Disadvantages of a Flat Income Tax Rate

With a flat tax system, revenue could be lost. Federal revenue was $3.3 trillion in Fiscal Year 2017. Half of that came from income taxes—corporate taxes only contributed 9%. 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. If the flat tax eliminates payroll taxes, then a third of federal income could be removed. The flat tax rate would need to increase to control the deficit. If the flat tax kept the payroll tax, then there'd still be a lot of complexity in preparing tax returns. 

A flat tax rate also leaves in place all state and local taxes, so families and businesses would still need to figure out those complex tax bills as well.

There's also the issue that a flat tax would eliminate taxes that wealthier individuals may pay, such as capital gains, dividends, and interest. This could shift the 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.

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

Senior citizens could end up facing double taxation. They've paid taxes on their income all their lives and a flat tax could require them to spend a portion of this after-tax income. They don't receive as much advantage from the elimination of income tax.

Flat Tax Proposals

Over the years, politicians and executives have proposed flat-tax rate systems. However, beyond the nine U.S. states with a flat income tax rate, the federal government has not yet taken steps toward a full flat tax system. But that's not to say it couldn't happen in the future.

In 2016, then-presidential candidate Ted Cruz proposed a 10% flat tax rate. His proposal raised the standard deduction to 10% and the personal exemption to $4,000, and 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 exempt from paying taxes. Families could still claim some existing tax credits, as well as deductions for charitable contributions and mortgage interest. Cruz's proposal also said that anyone could save up to $25,000 tax-free in a savings account. It would eliminate the estate tax, the Alternative Minimum Tax, and Obamacare taxes. It would also eliminate the payroll tax. The plan paid for Social Security and Medicare with a Value-Added Tax of 10% on imports.

Back in 2005, Steve Forbes proposed a 17% flat tax plan in his book, “Flat Tax Revolution.” In his proposal, everyone received an exemption: $13,200 for adults, $17,160 for single mothers, and $4,000 for dependents. A family of four wouldn't pay taxes if they made less than $46,000. His plan ended the estate tax and the Alternative Minimum Tax. Also, any income that was saved or invested would become tax-exempt, so no taxes on capital gains, Social Security benefits, interest, or dividends. Corporations could expense 100% of investments, doing away with depreciation schedules, and they would only pay taxes on American-made products.

The Bottom Line

A flat tax sounds like a great idea to many. It's simpler, would eliminate the IRS, and would cut back on tax fraud. But the tax rate would have to be very high to replace current federal revenue. Most flat tax proposals don't address payroll taxes to fund Social Security or state taxes and they're also often unfair to senior citizens who have already paid into income taxes during their working years.

A better solution may be to simply improve the current progressive tax system that we already have. If you have ideas on how to do that, you can contact your U.S. representatives and senators.

Article Sources

  1. European Central Bank. "Flat Taxes in Central and Eastern Europe." Accessed April 29, 2020. 

  2. Federation of Tax Administrators. "State Individual Income Taxes." Accessed April 29, 2020. 

  3. IRS. "Topic No. 751 Social Security and Medicare Withholding Rates." Accessed April 29, 2020. 

  4. Congressional Budget Office. "Revenues in 2017: An Infographic." Accessed April 29, 2020. 

  5. Tax Policy Center. "An Analysis's of Ted Cruz's Tax Plan," Page 20. Accessed April 29, 2020. 

  6. Tax Policy Center. "An Analysis of Ted Cruz's Tax Plan," Pages 2-3. Accessed April 29, 2020. 

  7. Steve Forbes. "Flat Tax Revolution: Using a Postcard to Abolish the IRS," Pages 60-67. Regnery Publishing, 2005.