A flat tax is one that has a set marginal rate. Flat taxes can be used for either personal or corporate taxes. In real world applications the flat tax often does allow for special deductions making most flat tax systems in reality a proportional tax. A closer examination of most flat tax systems and proposals shows that they are truly progressive taxes, with marginal flat tax rates.
There are several varieties of flat taxes discussed below:
- True flat tax – A true flat rate tax is a system of taxation where one tax rate is applied to all income with no deductions or exemptions.
- Marginal flat tax – A marginal flat tax is one that allows for certain deductions, but only up to a predefined limit at which point all income is taxed, making the tax structure marginally flat. Many of the proposed marginal tax systems simply exclude certain types of income from taxation (such as dividends or capital gains). In this case the tax is truly flat then on any taxable income.
- Flat tax with deductions – Another modification put forward for the true flat tax is a flat tax allowing for certain deductions, most popularly for charitable contributions and mortgage interest. There are also those who recommend a flat tax with a standard deduction, which as a side effect would simplify and streamline tax accounting because many low income families would no longer need to file tax returns.
- Hall–Rabushka flat tax – This is a tax on consumption designed by Robert Hall and Alvin Rabushka. It basically taxes income only and exempts profit from investments. Hall and Rabushka have worked with many of the Eastern Bloc countries in setting up their flat tax systems.
- Negative income tax – This is a form of flat tax put forward by Milton Freidman. It uses a flat tax allowing for deductions and is similar to the Hall-Rabushka model in that regard, however it also allows for negative income tax where the government would owe the household, rather than the household paying tax. For example if there were a standard deduction of $34,000 and a 20% flat tax rate then all income over $34,000 would be taxed at 20% while those making less than $34,000 would receive a 20% “refund” of the amount less than $34,000. The other benefit of this model is that it does away with many social benefits such as welfare, food stamps and Medicare.
- Capped flat tax – A capped flat tax taxes all income at a flat level until a certain amount is reached, thus capping the tax rate. The U.S. payroll tax is an example of a capped flat tax where the first $106,800 of income is taxed at a rate of 15.3% and everything above this amount is taxed at just 1.45%. Critics of the capped flat tax argue that it is a regressive tax and benefits the wealthy.
In the U.S. the idea of a flat tax has been gaining in popularity during the 21st century. In most cases the reasons for going to a flat tax in the U.S. are based more on simplification of the tax code. In 2009 the U.S. tax code consisted of over 72,000 pages of text. A migration to a flat tax based on the current 6 progressively marginal tax rates would take up just one quarter of 1 page.
Many of the countries of the Eastern Bloc have gone to a flat tax. The flat tax systems in these countries have been mostly praised as being successful, lending further credence to the claims of advocates for a flat tax system. To see a true pure flat tax one need only look to the state of Pennsylvania which taxes it’s residents at a flat 3.07% rate with no zero bracket amount.