Flat Tax

Flat Tax Definition

A flat tax is a taxation system whereby a uniform tax rate applies to all taxpayers irrespective of their income. Such a tax usually doesn’t provide any deduction or exemption to the taxpayers. As both rich and poor are taxed at the same rate under this system, it draws a lot of flak for being anti-poor.

Many countries take up this system to propel their economies and streamline their taxation process. Countries like Russia, Georgia, Estonia, Ukraine, and Lithuania have been using this tax system successfully. However, critics argue that it is a form of regressive taxation where the burden falls on the people belonging to the low-income category. At the same time, it allows an undue advantage to the individuals with high income.

Key Takeaways
  • Flat tax refers to the taxation of all income groups at a standard rate by the government. It is still prevalent in countries like Russia, Ukraine, and Georgia.
  • Under this taxation system, the government doesn’t facilitate any exemption or deduction to the taxpayers.
  • Income from other sources such as interest on securities, investment returns, capital gains, dividends on bonds, etc., are often excluded from the taxable income.
  • It is the inverse of progressive tax, where the high earning group is levied with a higher tax rate, and the lower-income class is either exempted or charged with low tax rates.
  • Even with an increased income, the tax rate remains the same. This motivates people to work hard.

How does Flat Tax Work?

Under this tax system, a person earning a higher income does not fall into a higher tax bracket. This acts as an incentive and encourages them to progress. However, since people with lower income are also taxed at the same rate, they are left with lesser disposable income.

This means that people earning less end up paying proportionately more than their well-off counterparts. This leads to critics arguing that this system increases the disparity between the rich and the poor.

Nevertheless, this tax system acts as a powerful stimulus for economic growth from an economic point of view. This is because it doesn’t punish individuals for generating a higher income or profit. Instead, it encourages people to spend or invest their excess earnings in the economy. This paves the way for the progress of a country’s economy.

Furthermore, this system simplifies the tax filing process sparing taxpayersTaxpayersA taxpayer is a person or a corporation who has to pay tax to the government based on their income, and in the technical sense, they are liable for, or subject to or obligated to pay tax to the government based on the country’s tax laws.read more countless hours of complying with complex tax codes. Hence, in some countries, politicians argue that governments should introduce a flat rate for taxation with certain exemptions and deductions to the lower-income group.

Features

Let us go through the distinct characteristics of the flat tax system to gain more information on it:

  1. Single rate of tax: A single tax rate is imposed on every individual irrespective of their income level. It is the easiest way of taxing the personal income of individuals.
  2. Low tax rate: The percentage charged under the flat tax system is usually lower than the progressive method. The personal tax rate in Russia is around 13%. On the other hand, the U.S., with a progressive tax system, charges 10-24%.
  3. Exempts income from other sources: The taxable incomeTaxable IncomeThe taxable income formula calculates the total income taxable under the income tax. It differs based on whether you are calculating the taxable income for an individual or a business corporation.read more under this method excludes the capital gains, earnings on investments, income from interest, dividends, etc.
  4. Deduction/exemptions not allowed: The tax is imposed at a uniform rate, and no deduction or exemption is permitted. However, on implementation, governments do allow certain deductions or exemptions based on conditions.
  5. Regressive in nature: This tax shows a regressive trend where the person with low income pays proportionately higher taxes, and a person with higher income pays lower taxes. However, the tax percentage remains the same for everyone.

Flat Tax Example

Suppose Mr. A and Mr. B have an income of $10,000 and $120,000, respectively. Their earnings are taxed at a flat rate of 12%. Their tax and disposable income are calculated as follows:

IndividualsIncomeTax rateTax Payable (Income * tax rate)Disposable Income (Income – tax payable)
Mr. A$10,00012%$1200$8800
Mr. B$120,00012%$14,400$105,600

From the above calculations, it is clear that Mr. A pays $1,200 and Mr. B pays $14,400 as tax. Thus, Mr. A will be left with a disposable incomeDisposable IncomeDisposable income is an important mechanism to measure household incomes, and includes all sorts of income such as wages and salaries, retirement income, investment gains. In other words, it is the amount of money left after paying off all the direct taxes.read more of $8800, while Mr. B will have $105,600 to spend. Therefore, this tax system leaves more money in Mr. B’s hands than with Mr. A.

Flat Tax

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This example shows how the lower-income group has less money to spend on their needs. But, on the other hand, this tax system doesn’t affect the wealthy individuals. However, the proponents of this tax system contend that it leaves the same percentage of money in the hands of both the lower and higher-income groups. Hence, this system is more or less fair.

Real-World Flat Tax Example

In the Tax Foundation‘s International Tax Competitiveness Index 2020, Estonia has emerged as the most competitive tax system among the OECD (Organization for Economic Co-operation and Development) countries.

Estonia’s flat tax mechanism for taxing individuals, corporations, and property is behind its success. The personal incomePersonal IncomePersonal income refers to the total earnings of the individuals and households of a nation through multiple sources such as salary, wages, business profits, bonus, investment returns, dividends, rental receipts, employer contribution in provident or pension funds, etc.read more is taxable at a flat rate of 20% for all residential earners. Also, the property tax is chargeable at the current land value, excluding the value of the structure. Other than these, the nation’s territorial tax implies that foreign profit is entirely exempted from the taxable income.

Furthermore, the country promotes savings and investments parallelly. Its corporate tax system allows the companies to set off all their cost of capital investment from their taxable income in the same year. Corporates are taxed at a flat 20%, applicable only to distributed profits.

As per an article published in the Guardian, the Labor party of Australia is trying to flatten the nation’s tax system slowly. It has eliminated the country’s capital gain tax policies and is supporting the stage three tax cuts. This will bring all the individuals falling in the $45,000-$200,000 income bracket under a 30% tax bar. However, it will ultimately benefit the high-income group and increase inequality in the nation.

Advantages and Disadvantages

A flat tax system motivates the individual to earn more to have a better standard of living. It also eliminates the discrimination between taxpayers. However, there is no exemption or deduction for the poor class, unlike the progressive tax systemProgressive Tax SystemProgressive tax refers to the increase in the average rate of tax with the increase in the amount of taxable income so that the liability of paying heavy taxes passes to those who earn a higher income and those with lower income can have a relaxation from the heavy income tax obligations.read more.

Furthermore, such a mechanism discourages bribery and tax evasion practices, i.e., misuse of taxation laws for escaping the tax liability. Also, an increase in revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more in the hands of the government is good for economies as the money can be invested in social welfare schemes.

Compared to the progressive tax, this tax is a more simplified form of taxation that makes the tax calculation and filing effortless. On the contrary, the taxpayers need not hire any professionals for tax filing, which significantly reduces their compliance costs.

However, many critics believe that a flat rate is an irrational means of taxation. This creates a hefty burden on the people struggling to meet their necessities and reduces their disposable income.

Instead of being motivated, the low earners feel deprived of the various benefits they deserve. Further, it refrains income redistribution in the nation; hence the poor become more vulnerable, and the rich people become wealthier. The government cannot relish a higher revenue from the high-income class when the flat rates are applicable.

Flat Tax vs Progressive Tax

The flat tax system contrasts the progressive taxation method. In the former, the government levies a single percentage of charges on everyone regardless of their income. However, in the latter, the government provides a tax slab bearing different tax rates for the individuals falling in different income brackets. Thus, as the individuals’ income shifts to a higher level, the tax rate is imposed at a higher percentage on them.

While the flat tax usually doesn’t provide tax exemptions or deductions, the progressive tax offers various exemptions or deductions to the taxpayers. In the former, the taxable income doesn’t comprise revenue from other sources like dividends and interest. The latter impose tax liability on the other incomes like capital gain, return on investment, etc. Moreover, the filing and computing of taxes at uniform rates are easily accessible by the taxpayers themselves. But for evaluating and filing the progressive taxation, the taxpayers require the services of professionals.

Flat tax puts a load over the daily wage earners and people who earn just enough to meet their basic requirements. On the contrary, progressive tax charges more interest from the wealthy taxpayers, penalizing them for higher revenues. The former assures equality among the individuals, while the latter ensures income redistribution in society to improve living standards. Russia and Ukraine have a flat tax system, whereas the U.S. and India use the progressive tax method.

Frequently Asked Questions (FAQs)

What is a Flat Tax?

A flat tax is a mechanism in which the same tax rate is applied to every individual irrespective of their earnings. At present, such a tax is primarily applicable on consumer products rather than personal income.

Why is flat tax bad?

Many people have criticized this tax system since it charges the same tax rate from the low and high earning individuals. Thus, the people with limited or meagre earnings don’t get any relaxation, contracting their disposable income on necessities. It, therefore, makes the poor poorer.

Is a flat tax regressive?

A flat tax often has a regressive tendency because it charges the same tax percentage from the low earners as it does from the wealthy individuals.

How is flat tax calculated?

A flat tax is computed through the simple interest method, where the amount of tax is equal to the tax percentage multiplied by the taxable income.

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