Forbes, who is worth nearly half a billion dollars, would see his tax burden more than cut in half, saving him millions of dollars a year. Meanwhile, those on the lower end of the income spectrum would see a more modest drop in taxes, if they see any difference at all. If you live in or work for a company in Mississippi, you might have to file a state income tax return. Maine residents will fall into one of three tax brackets. Indiana has a flat income tax, meaning you pay the same tax rate regardless of income.
This deduction allows some taxpayers to deduct the money they spend on state and local taxes. The AMT has its own set of tax rates and requires a separate calculation. Glossary F Flat tax Flat tax In a flat-tax system, everyone pays the same rate. What is a flat tax? Removing the deduction for charitable contributions would reduce overall giving and could affect its composition as well: Wealthy donors, for whom the write-off is now worth the most, tend to favor hospitals and universities; low-income donors, religious institutions.
Effects on businesses and investment would be complicated. The flat tax would eliminate corporate income taxes, put all businesses on an equal tax footing, reduce the statutory tax rate applied to business income, and make investment write-offs more generous. But it would also remove the deductibility of interest payments and of state and local taxes, and this could induce dramatic changes. The effects of a consumption tax on international economic transactions and on the financial sector are potentially far-reaching and need to be examined carefully.
Economic efficiency and growth Ultimately, increased economic efficiency and growth must be one of the key selling points of a consumption tax.
Without a significant gain in living standards, uprooting the entire tax system is probably not worth the risks, redistributions, and adjustment costs it would impose. Efficiency gains might arise from five sources: the change of the tax base from income to consumption; a more comprehensive tax base, which eliminates the differential tax treatment of various assets and forms of income; lower tax rates, which raise the rate of return to working, saving, and investing and reduce incentives to avoid or evade taxes; reduced compliance costs; and the taxation of previously existing assets during the transition to a consumption tax about which more later.
All but the first and last are attainable under income tax reform. Although estimates vary, a recent study suggests that a pure flat tax proposal with limited personal exemptions would raise economic output by between 2 and 4 percent over the first nine years and between 4 and 6 percent in the long run. But these results need to be interpreted carefully.
First, many of the gains are also available through judicious reform of the income tax, in particular by making the taxation of capital income more uniform. Second, the estimates provided do not allow for child exemptions, as the Hall-Rabushka proposal and all of the recent flat tax proposals do. Allowing exemptions for children reduces the effects by about 2 percentage points e. Third, the estimates apply to a pure, well-designed consumption tax. Compromises in the design, such as including mortgage interest deductions or allowing a transition, reduce the gains or turn them into losses.
Allowing for transition relief alone is enough to reduce the impact on growth to zero in the long run. The estimates also show that, even for welldesigned consumption taxes, efficiency losses are possible. The estimates cited in this paragraph are taken from Auerbach and private communications with Kent Smetters.
For additional analysis of the growth effects of tax reform, see Engen et al. A key element in raising growth and a major motivation for tax reform is increasing saving.
Proponents typically point to two reasons why consumption taxes should spur saving. First, a revenueneutral shift to a consumption tax would be expected to raise the after-tax rate of return on saving, while keeping total tax payments constant.
Second, consumption taxes reallocate after-tax income toward high-saving households. Such reasoning is straightforward but incomplete. Saving is likely to rise only a little, if at all, for several reasons.
First, the current U. About half of private savings already receive consumption tax treatment. Funds placed in pensions, k plans, Keogh plans, and most individual retirement accounts IRAs are not taxed until they are withdrawn. The return on these investments, then, is the pretax rate of return. But the introduction of a consumption tax would reduce the pretax interest rate, so that the rate of return on these forms of saving would fall, which could reduce saving in these forms.
Second, pension coverage could fall. Under an income tax, pensions are a tax-preferred form of saving. But a consumption tax treats all saving equally, making it less likely that workers and employers would continue to accept the high regulatory and administrative costs of pensions.
To the extent that workers did not resave all of their reduced pension contributions, saving would fall. Third, under a pure consumption tax, all capital existing at the time of the transition is implicitly taxed again when the capital is consumed. But transition rules likely to be added to a consumption tax to avoid this double taxation would reduce or eliminate the long-term effect on saving and growth, as noted above. The transition: Can we get there from here? Even if a consumption tax is the right system for an economy starting from scratch, it may not be the right way to reform an existing system.
Certainly, not having a transition is simpler. The transition rules could be very complex, and the transition period could stretch out for years. Not having a transition is also more efficient. Because future consumption can be financed only from future wages or existing assets, a consumption tax is a tax on future wages and existing assets.
A consumption tax that exempts old assets is just a tax on future wages. So exempting old capital removes any presumption that tax reform would result in a more efficient system.
Table of Contents. Definition and Example of a Flat Tax System. How a Flat Tax System Works. Flat vs. Progressive Tax Systems. Pros and Cons of a Flat Tax. By Kimberly Amadeo. Learn about our editorial policies.
Reviewed by Thomas J. Article Reviewed May 01, Thomas J. Brock is a CFA and CPA with more than 20 years of experience in various areas including investing, insurance portfolio management, finance and accounting, personal investment and financial planning advice, and development of educational materials about life insurance and annuities.
Learn about our Financial Review Board. Fact checked by Emily Ernsberger. Article Fact Checked October 17, Emily Ernsberger is a fact-checker and award-winning former newspaper reporter with experience covering local government and court cases. She also served as an editor for a weekly print publication. Her stint as a legal assistant at a law firm equipped her to track down legal, policy and financial information.
Percentages increase as income rises. Everyone pays the same rate. Wealthier taxpayers pay higher percentages. It often eliminates deductions and credits. Spending is rewarded through deductions. Key Takeaways A flat tax levies the same fixed percentage rate on all taxpayers. Examples of a flat tax include sales tax and Social Security and Medicare taxes. Article Sources. Your Privacy Rights.
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