Flat Tax

What is a Flat Tax?

A flat tax refers to a tax system where a single tax rate is applied to all levels of income. This means that individuals with a low income are taxed at the same rate as individuals with a high income.

Proponents of the flat tax system say that it encourages citizens to earn a high income without worrying that they will be punished for earning more, as is the case with a progressive tax system. However, critics say that a flat tax rate places an unnecessary burden on low-income earners since they remain with less income to sustain their standards of living.

Examples of Flat Tax

Example 1

Let’s assume that Peter, James, and John work at the same manufacturing company in Russia. Peter works as a technician and earns an annual taxable income of $40,000. James works as an accountant, and he earns an annual taxable income of $60,000. John works as the chief ICT officer, and he earns an annual taxable income of $80,000. Assume that the government imposes a flat tax rate of 15%.

Therefore:

Peter will pay (15% x 40,000) = $6,000 in annual taxes, leaving him with $34,000.

James will pay (15% x 60,000) = $9,000 in annual taxes, leaving him with $51,000.

John will pay (15% x 80,000) = $12,000 in annual taxes, leaving him with $68,000.

From the above calculations, the government takes $27,000 ($6,000 + $9,000 + $12,000) while the three taxpayers get to receive $153,000 ($34,000 + $51,000 + 68,000) cumulatively.

Example 2

In 2016, US Senator and presidential candidate Ted Cruz proposed the adoption of a 10% flat tax rate in the US. If implemented, the tax system would exempt a family of four with an income below $36,000 from paying taxes. It would raise the standard deductions to 10%, while the personal exemption would be increased to $4,000.

The flat tax system would also eliminate the estate tax, Obamacare taxes, as well as the Alternative Minimum Tax. The tax proposal would also reduce corporate taxes to 16%, while profits earned abroad would be tax-free. Businesses would only be required to pay a one-time 10% repatriation tax on past income.

Advantages of Flat Tax

One of the benefits of a flat tax rate is its simplicity; everyone pays tax at the same rate. It is simpler compared to the progressive tax rate, which imposes a different tax rate at various income levels.

For example, in the United States, the complexity of the progressive tax system costs taxpayers a lot of money and lost hours to implement it, resulting in different tax calculations for each taxpayer. However, with a flat tax, everyone pays a uniform rate, reducing the cost of its implementation.

Proponents of flat tax also say that the tax system is fair, compared to other tax systems. Every taxpayer is charged a uniform tax rate, and there are likely to be minimal complaints about certain categories of taxpayers being charged too high while others are charged too low. It is unlike the progressive and regressive tax systems where different groups of taxpayers are charged a different tax rate.

Disadvantages of Flat Tax

The opponents of the flat tax say that the tax system is unfair and that it places an excessive burden on low-income earners. Even though the system imposes a uniform tax rate for all income categories, it leaves low-income earners with less money to live comfortably and maintain their standards of living.

On the other hand, high-income earners are left with a lot of money to spend that is disproportionate to the net income after taxes for low-income earners. However, this criticism overlooks the fact that most flat tax proposals include an exemption from any taxation for the lowest income earners – like the exemption up to $36,000 in Senator Cruz’s proposal.

Flat Tax vs. Progressive Tax

The progressive tax system – In this tax system, a high tax rate is charged on high-income earners while the low-income earners are charged a lower tax rate. The progressive tax system is used in most countries, including the United States, and it is considered a more just tax system.

In the US (as of 2018), a person earning an annual taxable income under $9,275 pays a 10% income tax, while those earning above $500,000 are charged 37% income tax. The progressive tax system is designed to ease the tax burden on low-income earners; the burden is shifted to high-income earners with a large amount of disposable income.

Flat Tax vs. Regressive Tax

A flat tax rate shares a few characteristics with a regressive tax, which is where the tax rate decreases as the taxable income amount increases. A regressive tax system benefits higher-income earners as they pay gradually less tax the higher the income that they earn.

Under a regressive tax system, low-income earners lose a higher percentage of their income to government taxes, while the rich pay a smaller percentage, but a higher gross dollar amount.

Take the example of person A and B who earn $10,000 and $100,000 per annum, respectively, and they are subjected to a 15% tax rate for amounts below $50,000, and 5% for amounts above $50,000. This means that person A will pay a tax of $1,500 (15% x $10,000), while person B will pay a tax of $10,000 ($7,500 + $2,500).

After taxation, A and B are left with $8,500 and $90,000, respectively. Similarly, if a flat tax rate of 10% were imposed on both persons, A would pay a tax of $1,000 while B would pay a tax of $10,000.

Related Readings

CFI is the official provider of the Financial Modeling & Valuation Analyst (FMVA)® certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

• Ad Valorem Tax
• Canadian Income Tax Brackets
• Progressive Tax System
• Tax Shield
• See all accounting resources