Flat tax systems are ones that require all taxpayers to pay the same tax rate regardless of their income.
For example, a tax rate of 10% would mean that an individual earning $30,000 would pay $3,000 in taxes. An individual earning $1 million would pay $100,000 in taxes per year.
While such a tax system is just a concept in the United States, adopting it would dramatically simplify tax filing. In fact, most people could file their taxes with a piece of notebook paper and cell phone calculator. Here’s what you should know about flat taxes before your next chat with your friend who's an economics nerd.
What Is The Flat Tax?
A flat tax rate refers to any tax where all tax rates are the same. Technically, a sales tax could qualify because everyone pays the same rate on the products they consume. But when policymakers talk about flat taxes, they usually referring to a tax that would replace the income tax.
The most influential flat tax system was developed by Robert Hall and Alvin Rabushka back in 1985. Under this scheme, all household income would be taxed at a flat rate with some allowances (deductions) for family size. Subsequent versions of this system have been considered as the basis for sweeping tax policy changes in the United States.
Are Any Taxes Flat In The United States?
The United States has had a flat income tax twice in its history. But since 1913, federal tax system in the United States has been considered "progressive" or "gradual." That means the more money you earn, the higher rate you’ll pay.
Of course, there are deductions and credits and different forms of taxation depending on how you earn your income. That muddies the waters a bit, but at its core the income tax system in the United States is still a progressive one.
Nonetheless, there are notions of flat taxes in the United States. FICA taxes (Social Security and Medicare taxes) are the closest thing we have to one on a federal level. Every employee pays 7.65% of their income towards these taxes. Their employer kicks in another 7.65%. This leads to something close to a flat tax of 15.3% on all wage income.
However, earnings above $137,700 aren’t subject to Social Security tax. Since the tax isn’t applied equally to all earnings, the Social Security tax is technically regressive. Lower-income earners are taxed at a higher rate than high-income earners.
Additionally, many US states have a flat income tax. These states allow for deductions based on family size, but apply the same tax rate (ranging from 3.07%-5.25%) on all earnings above the deductible threshold.
Recent Calls For A New U.S. Federal Flat Tax
Over time, various politicians have called for a move to a flat tax system. Most recently, Republican Senator Ted Cruz unveiled a "Simple Flat Tax Plan" during the run-up to the 2016 presidential election. He reiterated his support for the tax reform plan during a Senate floor speech in 2017.
Senator Cruz's plan would have eliminated the "tax bracket" system and replaced it with a flat 10% tax rate. Under his plan, a family of four would pay no taxes on their first $36,000 of income. Cruz also promised that the plan would stimulate the U.S. economy to grow 14% in a decade.
Pros Of A Flat Tax System
The flat tax system is an interesting concept that could provide several advantages. Here are some of its most notable potential benefits.
Ease Of Collecting Taxes
The IRS code is extremely complex. The Tax Cuts and Jobs Act of 2017 did reduce the number of taxpayers who need to pay the alternative minimum tax and who would benefit from itemizing their deductions. But a flat tax could simplify both the business and individual law codes at a dramatically higher level.
Easier To Balance A Budget.
The flat tax makes it easier to predict short and long-term budgetary inflows. When Congress knows how much money it will take in, it can more easily manage a balanced budget in the long run.
No Disincentives To Work
One of the criticisms of the current social safety net and income tax structure in the United States is that it provides a disincentive to work after a certain point. The government-provided benefits “fall off a cliff” while the tax rate goes up.
The result is it can be difficult to escape from a working poor lifestyle. Ideally, giving everyone the same tax rate would fix those disincentives and make each dollar earned worth the same as the previous.
That means people with opportunities to work more would be fully rewarded for taking them. Of course, that ideal scenario would require modifying existing social programs in addition to the tax code.
Reduce Tax Code Loopholes
One of the major benefits of moving to a simplified tax system is that there would be fewer opportunities for taxpayers to "game" the system. Plus if businesses were charged a flat rate too, it would discourage the government from creating tax code rules that benefit (or hurt) certain companies or sectors.
Cons Of A Flat Tax System
Despite some enthusiasm from tax policy centers, and Neoclassical economists, the flat tax bill hasn’t been met with much enthusiasm in the United States. Here are a few reasons why.
Higher Tax Rates For Some People
Although the allowances for family size and necessary consumption would technically make it a “fair tax,” it seems likely that overall tax rates would increase for low-to-middle citizens without providing them with additional benefits.
Conversely, tax rates would likely fall for those at the top of the income spectrum. A study by the Congressional Budget Office (CBO) in the 1990s found that a flat tax system would lead to a nearly 22% decrease in after-tax income for the lowest earners while increasing after-tax income by approximately 7% for the highest earners.
This perceived unfairness makes the system less politically palatable, even if overall tax revenues increased. In response to these concerns, some experts have recommended that adopting a flat tax system that only applies to income above an exemption floor. For example, if the exemption was $25,000 and you earned $75,000 in wages, you'd only pay income tax on $50,000.
Defining "Income" Can Be More Challenging Than You Think
A big part of the tax code doesn't have to do with rates or what you pay - rather, how do you define income. The current tax code is 2,600 pages long, but the rates you pay only take up 2 of those pages. The remaining pages all define "income" - from where or how it's earned to when you have to claim it as income.
While most employment income is pretty easy to define, when you get into things like mining, farming, or investments, things can get very complex very quickly.
Furthermore, the United States has used the tax code to incentivize (or disincentivize) certain activities. For example, the encourage homeownership, homeowners get the mortgage interest deduction. If these types of incentives are no longer going to be a part of the tax code, we either have to find different ways to incentivize activities or you could argue we should discontinue these types of behaviors.
Tax Rates May Fluctuate Over Time
A flat tax rate sounds like a panacea for knowing what your taxes will be. However, budgetary shortfalls may push tax rates up over time. If the tax rate becomes high enough, incentives to leave the United States to avoid taxation could present themselves.
Final Thoughts
The tax landscape in the United States leaves much to be desired and a flat tax system offers several compelling advantages over the existing system. It’s easy to calculate, it would close existing tax loopholes, and make a national budget easier to predict. However, a flat tax is unlikely to be implemented anytime soon here in the United States.
For now, the United States has a progressive tax code filled with many opportunities for tax deductions or credits. Under the current code, every taxpayer may qualify for one or many deductions or tax credits that reduce their tax burden. If you’re not sure how to claim tax deductions or credits, you’ll want to use a tax filing software. This article outlines the best tax software for your situation. Be sure to check out the section on maximizing credits and deductions.
Robert Farrington is the founder of The College Investor and is widely recognized as one of the nation’s leading voices on student loan debt and saving for college. He holds an MBA from UC San Diego Rady School of Management and has spent over 15 years researching, writing, and advising on student loans, 529 plans, financial aid programs, and saving and investing for young professionals.
Robert has been featured in the The New York Times, The Wall Street Journal, The Washington Post, NBC News, and Forbes, where he has been a regular personal finance contributor for over a decade. His work combines both professional expertise and personal experience – he successfully navigated his own student loan repayment journey and has helped thousands of readers do the same.
He is committed to making the intersection of personal finance and education transparent and accessible. You can learn more about Robert on the About Page or on his personal site RobertFarrington.com.