Flat Tax over the Current Tax

Policy

The focus of this paper is to demonstrate effectiveness of flat tax over the current tax rate. Presently, the U.S. government employs progressively tax law as the current tax policy. Under the current tax policy, the government increases taxes with increase in income. Analysis of the current tax policy reveals that the tax system is very complicated to understand because corporate organizations face multiple taxations in a fiscal year. Moreover, the current tax forms are very complicated for an ordinary taxpayer to understand. Based on the complications associated to the current tax policy, this paper proposes the flat tax policy that will make all businesses and individuals to pay equal tax rate. The paper provides several benefits of flat tax policy over the current tax system. For example, the flat tax will adopt the basic principle of taxation. The tax returns of the proposed tax system will be easy for the business and individual to file. Moreover, the flat tax system will boost the U.S. economic growth because virtually all sectors will record higher productivities.

Introduction

The flat tax is the system of tax rate where every taxpayer pays the same tax rate regardless of income bracket. A flat tax system employs the same tax rate to every individual with no exemption. Supporters of the flat tax argue that the tax policy will give taxpayers incentives to earn more because taxpayers will not be forced into paying a higher tax bracket. Supporters further argue the tax system is fairer because the tax system will provide incentive for people to earn more income because they will not be penalized for higher income. The United States is currently using a progressive tax rate where higher income earners pay higher percentages of tax rate than lower income earners. Under progressive tax rate, people earning up to $8,375 per year pay 10% tax bracket while people earning income greater than $373,650 pay 35% tax bracket. Under a progressive tax policy, individuals who make higher income pay higher tax rate. Contrary to the United States, many countries use flat tax rate system on business and individual. For example, Lithuania, Latvia and Estonia are currently using flax tax rate and these countries are recording economic growth since adopting flat tax rate systems.

Objective of the paper is to demonstrate that flat tax rate is better than the current tax rate that the United States is currently adopting.

The study uses theoretical frameworks to explain the reason the flat tax rate is better than the current tax policy. The study uses CGE (computable general equilibrium) model to investigate the effect of the flat rate system on the economy. Opponents of the flat tax rate claim that the system will benefit the rich disproportionally, make lower income earners to be worse off and increase the federal budget deficit. Using 17% flat tax rate, this paper argues that the current tax rate declines the U.S. growth rate because it affects savings negatively. Using the CGE model, the flat tax rate will be beneficial to the whole economy because the entire sector will record a growth rate.

Complexities of Progressive Tax Rate

Presently, the United States is currently applying progressive tax system where the share of income tax paid increases with rise in income. Typically, the progressive tax system is characterized by the inequality of tax system because all income earners are not paying the same tax rates. Piketty, & Saez, (2006) point out that everyone in the United States pay the share of progressive tax as rise in income. Contrarily, regressive tax occurs when the share of tax paid decline as income decrease. However, the current tax is so much complicated to be understood by an ordinary taxpayer. For example, the current tax system costs tax payers more time spent worth more than one hundred billion dollars in order to comply. Moreover, the current tax system costs the economy more than several hundred of billion of dollars of wasteful investment because it leads to more than hundreds billion of dollars of tax evasion and cheating. More importantly, the current tax system encourages lobbyists and lawyers to seek for tax favors from Congress and tax authorities instead of earning an honest living.

The current tax law is so complex that it consumes enormous quantities of paper and ink of West Publishing Company, an official publisher of the federal government tax code. The complexity of the current tax code has led to grown up of massive tax industry ranging from the service of tax lawyers, tax scholars, tax planners, tax accountants, to tax filers. Moreover, the IRS has 140 tax forms, the common one is Form 1040 and another 280 forms to explain the 480 tax forms. Thus, the current tax system constitutes thousands of pages in order to explain all forms to ordinary taxpayers. The complicated of current tax policy makes ordinary citizen feel threatened and overwhelmed by the service of IRS (Internal Revenue Service). Moreover, the current tax system imposes huge costs on American people:

Compliance costs, welfare costs, indirect economic losses, and tax court cases.

Understanding the tax requirements such as copying, preparing, and sending forms,

Generally, the current taxation is designed to decline income disparity between the upper income earners and lower income earners thereby redistributing wealth using a welfare state model. Since the early 20th century, government has been using progressive taxation policy to increase tax with increasing level of incomes and assets. The major objective of progressive taxation is to redistribute the burden of government taxation from lesser income earners to people having more affluent. Analysis of the progressive taxation model shows that progressive taxation has failed to reduce real income disparity between upper and lower income earners. Typically, the current tax policy is an inefficient tax policy because it causes the national economy to be smaller in three ways:

1. By failing to levy tax on capital as well as other production input at uniform rates. Thus, the tax policy prevents efficient allocation of resources and prevents resources to be allocated to the highest value.

2. Moreover, it creates the loopholes, exemptions and exemptions. Moreover, it creates marginal rates much higher on all inputs that needs to be, and

3. The taxation on investment income creates lower capital stocks that would have otherwise created.

Hartman, (2009) points out that theoretically tax share paid should increase after the government tax the increase in income. However, meticulous analysis of tax share vs. income between 1957 and 1997 reveals that there is no obvious cause and effect. “Instead, there has been an evident negative relationship between tax share paid by the top 10% of incomes and the after-tax income share of the other 90%. In other words, when tax share of the top 10% goes up, the after-tax income share of the other 90% goes down.” ( Hartman, 2009 p 1). This evidence strongly suggests that the progressive taxation has lowered the real income effects of marginal taxation of intellectual and financial capital. Thus, federal government needs to adopt a more effective taxation policy to enhance economic efficiency. Typically, progressive taxation does not encourage productivity in the economy because it leads to unproductive misallocation of assets due to confiscation of the efforts of productive citizens.

Weller, & Rao, (2008) argue that progressive income tax affect the income formation in the United States because progressive tax policy reduce amount of money left for private savings that an individual will have for domestic investment. The effect will translate into a higher cost of capital and consequently impede physical capital formation. Additional impact of progressive taxation is that it can adversely affect skill development and it may discourage unskilled workers to develop their skills. With increase in tax rates as income rises, many workers will be discouraged to further their education and people who have already accumulated higher skills may emigrate out of the country to search for employment in countries that practice flat rate taxation policies. Thus, progressive taxation may lead to brain drain and leave the country with mass of unskilled labor. Thus, the progressive tax will discourage people to work hard.

Typically, the practice of progressive taxation policy reveals that it encourages disincentive to invest in activities such as financial risk-taking, investment and entrepreneurship, and these are real engines to economic growth. Thus, the progressive taxation will encourage brain drain because individual with higher earning potentials are often the nation’s most talented people. Forcing them to pay higher tax may make the considering relocate to other countries that adopt lesser tax effects. Moreover, current tax system may increase unemployment situation in the country because the taxation model discourage business expansion and investment. To avoid higher corporate taxes, many corporate organizations may decide to expand their business and invest broad rather than investing domestically. Thus, the progressive taxation is arguably seemed unconstitutional because it treats all citizens unequally and differently. The complexity of the current tax law has made the U.S. lawmakers considering switching to flat tax policy to remove complication associated with the current tax system in order to improve economic efficiency and growth as well as removing double taxation associated with a progressive taxation. The flat tax system arguable will attract capital investment in the country as well as improving business climate. Under a flax tax option, the government will tax all incomes at the same rate after tax authorities apply all personal allowances.

Many known politician have already advocated for a flat tax policy in their campaign. Steve Forbes advocated for a tax option in his campaign during the Republican presidential nomination. Senator Richard Shelby and Representative Dick Armey have already proposed the Fairness and Freedom Restoration Act that proposes a flat tax rate of 17% and personal allowance of:

$11,350 for an individual, TO BE REVISED

$14,850 for a single household, $22,700 for a married couple

$5,300 for each dependent. TO BE REVISED

Opponents of flat tax option claim that the new system will impose a considerate burden on the lower income earners because the tax rate will eliminate the “Earned Income Tax Credit.” They further argue that the flat tax rate will benefit the wealthy people and higher income earners because it will abolish the personal income tax on dividends, interests, and capital. However, supporters of a flat tax policy view all these taxes as double taxation because the capital gains are taxed at business level. Since flat tax system will abolish inheritance tax, the opponents claim that flat tax will increase national debt and federal deficits.

Despite the claims of the opponents of flat tax system, this paper argues that the current tax option is too complicated for ordinary taxpayers. Ordinary taxpayers cannot file the tax returns by themselves because they find the current tax system too complicated to understand. Moreover, the current tax policy does not encourage marginal propensity to invest which consequently discourage economic growth. (Martinez-Vazque, & Timofee, 2011).

Effectiveness of Flat Tax System over the Current System

The economic theory provides ten principles of good taxation and they are as follows:

1. Equity and fairness,

2. Certainty,

3. Convenience of payment,

4. Economy in collection,

5. Simplicity & Understandable,

6. Neutrality,

7. Efficient and Economic growth

8. Visibility and Transparency

9. Minimum tax gap,

10. Appropriate government revenues. (Nellen, 2006).

The analysis of the current tax policy reveals that it is not simple for ordinary tax payer to understand. Moreover, the current tax policy increases as there is an increase in income, which does not follow the minimum tax gap. Moreover, the current tax policy does not follow economy in collection because costs of collection are enormous. The IRS uses billion of dollars yearly to collect taxes from taxpayers. (AICPA, 2001).

The flat tax will remove the complexity of filing tax returns by individual and corporations. The flat tax system will rest on simpler administrative principles where corporate and individual income should be taxed once. Typically, current tax policy violates principle of taxation because capita gains and dividends are taxed twice.

More importantly, the flat tax is very simple to adopt unlike the current tax laws that are so complex to understand. Typically, the current tax system encourages tax cheating and avoidance. Moreover, the current tax policy costs the government billions of dollars to administer. Moreover, it costs taxpayers time spent that worth billion of dollars to fill the tax form and other form of compliance. Moreover, the current tax system costs the economy billion of dollars in term of lost output in form of goods and services because the time wasted for the tax purpose would have been used for investment purposes. The flat tax policy will remove complicated depreciation deduction and replace it with a favorable capital formation, revealing an immediate write off investment spending by 100%. Typically, the system is a value added approach leading to the consumption taxation. Under current tax policy, the fringe benefits make no sense.

Under the flat tax system, each corporation will file a simple tax form. Even larger business such Microsoft Corporation will file a simple tax form and every line will in the form will compose of well-defined number that will be obtained directly from business accounting record. The simple individual tax form and business tax form are presented below.

Form 1

Individual Wage Tax

Your first name and initial (if filing for joint return, give spouse’s name and initial) Last name

Your social security number

Present your home address (number and street, apartment number)

Spouse’s social security number

City, town, state, and ZIP code

Your occupation

Spouse’s occupation

1

Wages and salary

1

2

Pension and retirement benefit

2

3

Total compensation

3

4

Personal allowance

a) $16,500 for married couple filing jointly 4(a)

(b) $9,500 for single 4(b)

(c) $14,000 for single head of an household…. 4(c)

4a

4b

4c

5

Number of dependents, this is not including spouse

5

6

Personal allowances for family dependents (line 5 multiplied by the $4,500)

6

7

Total personal allowances

(line 4 plus line 6)

7

8

Taxable compensation

(line 3 if less go to line 7, and if positive; otherwise zero)

8

9

Tax (17% of line 8)

9

10

Tax withheld by employer

10

11

Tax due (line 9 less line 10, if positive)

11

12

Refund due (line 10 if less and line 9, if positive)

12

Form 1

Business Tax

Business name

EIN (Employer identification number)

Street address

County

City, state, and ZIP code

Principal product

1

Gross revenue from sales

1

2

Allowable costs

(a) Purchases of goods, and services, and materials

(b) Wages, pensions and salaries,

(c) Purchases of equipment, capital structures, and land

2

3

Total allowable costs (sum of the lines

2(a), 2(b), 2(c)

3a

3b

3c

4

Taxable income (line 1if less line 3

4

5

Tax (17% of line 4)

5

6

Carry-forward from 2013

6

7

Interest to be carry-forward (6% of line 6)

7

8

Carry-forward into 2013 (line 6 plus line 7)

8

9

Tax due

(line 5 if less line 8, if positive)

9

10

Carry-forward to 2013

(line 8 if less line 5, if positive)

10

Current economic recession that has led to the rise of national debt and budget crisis has made increasing number of Americans to call for a new tax reform for both corporate organizations and individuals. Bressler, et al. (2010) argue that U.S. corporate tax rates is the among the highest in the industrial world. The major shortcoming of the progressive tax rate is that it discourages incentive to invest. The negative impact of the current tax rate makes the flat tax policy to gain increasing attention. The flat tax will boost incentive to invest because the business will be able to enjoy immediately tax deduction for investment in equipment ad plant over the course of many years. Moreover, the flat tax regime will eliminate double taxation associated with progressive taxation currently paid on capital gains and dividends.

Typically, current economic climate provides impetus for economic reform. There is argument among tax theorists and economist that the best tax system is one that will strike optimum between equity and economic efficiency. (Hagopian, 2011). An efficiency tax system should not distort the country allocation of resources. It should also not alter investors’ behaviors. Arguably, the flax tax is simple because it eliminates most tax deductions, preference, and credits. Typically, flat tax policy simplifies tax code because it reduces cost of compliances. The flat tax will influence the growth of American economy and improve incentives to work. Moreover, the flat tax rate policy will encourage entrepreneurial activity as well as capital formation, which will substantially increase people’s standard of living. Although, there are group who against the flat tax policy because they suspect that the system will give away to the rich by levying equal tax redistribution. However, Seldom, (?1996) argues that the flat tax rate of 17% will stimulate economic growth because everybody will be encouraged to work which will enhance performances of the U.S. economy. Improved incentive to work will enhance take home wages of an individual, and the system will stimulate work effort which will eventually stimulate investments into most productive channels in the country.

Moreover, flat tax rate will enhance critical inputs into the economy. Since there is only one tax levied on corporate organization and individual, the flat tax will remove distortions associated with the current tax system. Typically, the current tax policy allows distortion in the economy that consequently discourages capital inputs. Under the current tax system, varying tax treatment and different marginal tax rates make the government to tax capital and other inputs differently from industry to industry. For example, average effective tax rate in the U.S. economy is 36.4% however, average tax rate on tobacco and food industry is 46%, manufacturing sector pays 40% tax rate, tax rate on agricultural crops industry is 26% while financial sector pays average tax of 32%. ( KPMG, 2014). The effect is that there is overinvestment in financial sector and agricultural crops industry than other sectors in the economy. Thus, the flax tax policy will move tax system to uniform rate, removing distortion and stimulate economic growth.

Moreover, the flat tax policy will remove loopholes, deduction and exemptions. In the United States, more than 50% of lower income earners are not taxed. The flat tax system will remove distortion of the current tax system because all income is taxed once since there will no other exemptions, deductions, and loopholes. (Gaddy, and Gale, 2005, Larsen, Thomas, (2006).

The flat tax policy will remove anti-saving bias. Under the current tax system, the government levies taxation on what people earn and save, which results into double taxation. People are taxed again when their saving earn returns and tax again when they die. Thus, the current tax system encourages consumption and discourages savings. The multiple tax system on investment is hampering economic growth making the United States to record lower capital formation than what the country would have recorded if adopting flat tax policy. Under the flat tax policy, the government will not tax saved income at individual level. The flat tax encourage saving and promote investment activity because investment is real capital assets that are expensed when it is made and not depreciated.

One of the most beneficial aspects of the flat tax rate is that it will stimulate work effort. Approximately two-third of tax payers enjoy low tax rate of 15% under the current tax system. However, under flat tax rate, this group will enjoy zero tax rates because their earnings will family short of $25,000 for family earning. The other half of wage earners will be taxed with a margin of between 15% and 17%. The net effect of flat tax policy is that it would dramatically improve incentive to work because everyone who is economically active will be willing to work. A switch of current tax law to flat rate law will increase total hour of work by 4% making the U.S. economy to rise by 3% with almost $200 billion rise in output of goods and services.

Capital Formation

Moreover, the proposed tax reform will enhance capital formation within the economy. One of the major defects of current tax system is that it discourages capital formation in the economy because it heavily tax business incomes, which consequently erode an investment incentives. Moreover, the current tax system heavily tax capital formation, the results lead business people to channel investments into inefficient use. The most important bias on current tax rate is that its double taxation on business income paid to shareholders and earned within the company.

“Double taxation dramatically reduces the incentive to create new businesses in risky lines where debt financing is not available.” (Hall, & Rabushka,2007, p 5). The flat tax policy will eliminate harmful effect of current tax system because the flax tax will have uniform and single incentive for businesses and investment. For example, the flat tax system will treat all purchase of building and equipment as expenses, which will allow immediate write off investments. While there is disagreement about the impact of flat tax, however, all economists agree that flat tax policy will enhance capital formation in the economy and increase capital stock to GDP ratio from 5.0 to 6.2, which will reasonably increase the GDP by 2%. Moreover, the country will enjoy 3.2% increase in capital stock making GNP to rise by 0.8%. (Hall, & Rabushka,2007).

Effect of Flat Tax Policy on the Economy

The most important aspect of the flat tax policy is its ability to stimulate the economy. The flat tax rate will remove distortion of the current tax rate and assist in stimulating economic output because it will enhance disposable incomes of all income levels. Moreover, increase in disposable incomes in the country will increase consumption levels across all sectors, which will consequently lead to an increase in consumption of goods and services. As being revealed in table 1, the country will record a growth of 2.6% in chemical and plastic industry, which has been categorized as manufacturing industry. The food and tobacco sector will also increase by 3.5%. Essentially, the increase in growth of chemical and plastic industry and food and tobacco industry is because these industries are very important to other industry. They serve as sources of materials to other industries that produce consumer goods and services. Similarly, increase in output within the food and tobacco industry will lead to an expansion in non-program crop and livestock boundary.

Table 1: Productive Sector

% Change in Quantity

Manufacturing

3.6%

Food and Tobacco

3.5

Wood Product

3.1

Service except Finance

2.8

Petroleum Refinery

2.6

Chemical and Plastics

2.6

Crude oil and Natural Gas

2.6

Financial Services

1.5

Livestock

2.5

Program crop

(0.8)

Non-program Crops

1.7

Other Mining

3.5

Logging

0.0

As being revealed in the Table 2, the Flat tax rate will lead to the growth rate in consumption sector. Typically, the growth rate of all sectors ranges between 2 and 4% except financial service industry, which will record a negative growth rate. Moreover, the flat rate policy will enhance the growth of housing sector by 1.5% because the government will no longer deduct mortgage interests under the flat tax system and the expansion is attributed to the growth in disposable income of all lower, middle and higher income groups.

Table 2: Consumption Sector

% Change in Quantity

Food

3.6

Consumer Service except Finance

2.3%

Savings

7.4

Clothing and Jewelry

3.6

Housing

1.5

Motor Vehicles

3.2

Reading and Recreation

3.2

Non-durable House Items

3.9

Alcohol and Tobacco

3.9

Gasoline and Fuel

3.2

Transportation

2.8

Utilities

2.9

Financial Services

(0.2)

Furnishing and Appliances

3.2

Increase in saving is the most significant impact of flat tax rate because it will cause the saving to increase by more than 7% and its increase will be two times greater than other sectors in the economy. In the United States, saving is critical to fuel the economic growth. Major reasons that will lead to the growth of savings are as follows:

First, interests and dividends are not taxed at the household and individual level because they have already being taxed at the corporate and business level. The incomes of all income groups will increase thereby boost investment opportunities in the country as being revealed in Table 3.

Table 3: Effects on Income

Under Current Taxation

Under Current Taxation

Change in Disposable Income

0-$9,999

0-$12,881

+7.6%

$10,000-$19,999

$12,882-$25,764

+1.6%

$20,000-$29,999

$25,765-$38,646

+2.5%

$30,000-$39,999

$38,647-$51,529

+1.4%

$40,000-$49,999

$51,530-$64,412

+1.0%

$50,000 and up

$64,413 and up

+2.4%

Source: Bureau of Labor Statistics

However, critics of the flat tax policy maintain that the system will benefit the wealthy people at the expenses of middle class. Some critics also maintain that the flat tax will make lower income earners to be worst off if the government removes the EITC (Earned Income Tax Credit). However, the critics have ignored that a flat tax policy will affect different income group in different way and will influence changes throughout the economy. Typically, the flat tax will eliminate the efficiency making the economy to become larger. The result will make all income groups to be better off because of a flat tax policy. ( Gale, 1996).

As being revealed in Table 3, the lower income group will record highest income gains compared to other income brackets. Typically, lowest income group will gain 7.6% increase in their income compared to other income groups. The gain of the 7.6% is explained on the ground that these group will no longer pay income tax with the advent of flat tax rate making them willingly to supply their large quantity of labor. The expansion will have cumulative expansionary effects in virtually all sectors of the economy.

Table 4: Income Group Under Flat Tax

Land

Labor

Capital

Total

0-$9,999

2.8%

61.1%

36.0%

99.9%

$10,000-$19,999

1.9%

81.8%

16.3%

$20,000-$29,999

0.9%

85.8%

13.3%

$30,000-$39,999

0.7%

86.8%

12.6%

$40,000-$49,999

0.4%

88.3%

11.3%

$50,000 and up

0.3%

84.6%

15.1%

Source: Bureau of Labor Statistics

As being revealed in the Table 4, the lowest income group receives the highest percentages of its income from capital and land. Typically, this group receives benefits larger percentages from land and capital more than other groups on percentages basis after a flax tax is imposed. The lowest income group receives 36% of their incomes from capital under flat tax system because this group is mostly self-employed and takes little salary. Thus, they will not be taxed for ownership of capital compared to company owning capital that receives income from capital. Apart from benefiting all income groups in the economy, the 17% of flat tax system will also increase government revenue by 1.8%. The increase in the government revenue is attributed to the increase in productivities by virtually all sectors in the economy accompanying to the increase in employment in land labor and capital.

Conclusion

This paper proposes the flat tax policy to replace the current tax system because of complication associated to the current tax system. The current tax system is a progressive tax policy that increases tax rates on taxpayers with increase in income. However, this paper argues that the current tax law is very complicated for an ordinary tax paper to understand. The paper proposes the flat tax law that levies equal tax rate no matter the level of income. The paper demonstrates that the flat tax policy will be easy to understand and will boost the U.S. economic growth.

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