Flat Tax with Its Pros and Cons

Why a Flat Tax Might Increase Your Tax Bill

Woman calculating receipts for taxes
••• Tooga / Getty Images

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 its true revenue producing potential.

Examples

In 2016, presidential candidate Ted Cruz proposed a 10 percent flat tax. It raised 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 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. That's a 10 percent tax on imports. 

The Cruz flat tax lowered the corporate tax rate to 16 percent. Businesses could exempt from taxes100 percent of the cost of equipment. The plan eliminated taxes on profits earned abroad. Companies would be taxed 10 percent on a one-time repatriation of past income. Goods made for exports would be tax-free. Cruz would "abolish the IRS," and replace it with something smaller. 

In 2005, Steve Forbes proposed a similar 17 percent flat tax plan in his book, “Flat Tax Revolution.” In this, 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 make less than $46,000. His plan ended the estate tax and the Alternative Minimum Tax. Also, any income that was saved or invested became tax exempt. That meant no taxes on capital gains, Social Security benefits, interest, or dividends. Corporations could expense 100 percent of investments, doing away with depreciation schedules.

They only paid taxes on American-made products.

Advantages

A flat tax would have three advantages. The biggest advantage 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 the salaries of the 97,440 Internal Revenue Service employees to that cost.

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.  So those with the most sophisticated tax preparers pay the least in taxes. That can increase income inequality

All this complexity allows greater fraud and cheating. The simplicity of a flat tax would improve compliance.

Disadvantages

The flat tax has four disadvantages. First, most proposals don't replace the revenue from the existing tax system. For example, federal revenue was $3.3 trillion in Fiscal Year 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. Most families and businesses must still spend almost 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.

Fourth, it imposes double taxation on seniors. They've paid taxes on their income all their lives. The flat tax would require them to spend a portion of this after-tax income on a new cost. They don't receive as much advantage from the elimination of the income tax.

Flat Tax Versus Fair Tax

The Flat Tax is an income tax. The Fair Tax is a sales tax. Both eliminate the complicated current income tax structure. But 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.