If you’ve ever filed taxes, you know what a headache it can be when you’re forced to navigate through intricate tax codes. Some politicians, financial analysts, and economists have suggested implementing a flat tax rate system in place of the current progressive tax system already in place in most states.
There are both benefits and drawbacks of a flat tax rate, especially for those in the extreme poles of tax brackets—the highest wage earners and the lowest.
Keep reading for a comprehensive explanation of flat tax rates and how they affect your taxes already and may impact them in the future.
What is a flat tax?
A flat tax rate simply means that everyone pays the same tax rate regardless of their tax bracket. So, if the flat tax rate was 10%, those who made $100,000 would pay $10,000 in taxes. If someone made $50,000 in a year, they would be obligated to pay $5,000 in taxes.
Currently, there are eight states that have a flat tax income system which will be explored in detail below. There also a few eastern European countries like Latvia, Lithuania, and Russia that use flat tax rates, as well.
What is the purpose of a flat tax system?
The main philosophy behind a flat tax rate is that it helps boost the economy because it both simplifies taxes and encourages people to save rather than spend their earnings.
Russia is the biggest economy in the world that uses a flat tax which comes out to 13% for all earnings. Has it made a difference? With the aforementioned Eastern European countries and Russia as case studies, these countries have all historically enjoyed economic growth since moving to this type of tax system.
In general, many economists believe the benefits of flat taxes outweigh the drawbacks because they tend to raise revenue without negatively impacting the economy. And one main reason why some states have moved to a flat tax is to avoid what’s referred to as “double taxation.”
What do we mean by double taxation? It’s a tax principle that refers to income taxes paid twice on the same source of earnings. Let’s dive into an example to see how this might play out in real life.
If someone earns $500, for instance, he or she must decide between spending that money immediately or, either saving or investing that income. If the individual decides to spend it immediately, those earnings get taxed once through the individual income tax. But if he or she chooses to save that money, it’s going to be taxed again, once through an individual income tax and then again on any dividends.
In a “pure” flat-rate tax system, dividends aren’t taxed, eliminating the issue of double taxation.
Are there states with a flat tax income system?
The states that have flat taxes as of 2019 include the following states below:
- Colorado: 4.63%
- Individual taxpayers can claim the standard deduction of $12,200 and those filing who are married can claim $24,400. Colorado offers no personal exemptions.
- Illinois: 3.95%
- A personal exemption is allowed for individuals, $2,225 per individual, $4,450 for married couples, and $2,225 for dependents. But there is no standard deduction available.
- Indiana: 3.23% to 3.23%
- Personal exemptions are as follows: $1,000 for single persons, up to $2,5000 for each of your dependents, and $2,000 for married couples who file together. Indiana offers no standard deduction.
- Kentucky: 5.0%
- Kentucky adopted the flat tax rate in 2018. The standard deduction for individuals or for those who are married is $2,530. This state offers no personal exemptions.
- Massachusetts: 5.05%
- There is no standard deduction available. But for personal exemptions, you can claim $4,400 for single taxpayers and $8,800 for married taxpayers filing together. Personal exemptions for dependents are $1000 each.
- Michigan: 4.25% to 6.65% (depending on the city)
- There is no standard deduction available but personal exemptions for both single and dependents are $4,050. For those filing jointly, you can expect an $8,100 personal exemption.
- North Carolina: 5.25%
- Individuals can claim $10,000 for their standard deduction and those filing jointly can claim $20,000.
- Pennsylvania: 3.07% to 6.9509% (depending on the municipality)
- Pennsylvania has no tax exemptions or standard deductions for individual taxpayers and their dependents.
- Utah: 4.95%
- Utah offers a nonrefundable tax credit equal to 6% of your federal deduction and allows for personal exemptions.
Are there federal taxes that are flat rates?
Yes. Both Medicare and Social Security taxes are already in place as flat-rate taxes. American employees pay 6.2% of their income into Social Security up to an earnings limit of $132,900 in 2019. Anything above $132,900 is exempt. Additionally, employers pay an additional 6.2% for Social Security taxes, bringing up the total to 12.4%.
For Medicare, U.S. employees pay 1.45% of their earnings with no cap on income that can be taxed.
What are the benefits of a flat tax system?
The proponents of the flat tax system argue it’s a more fair way to apply taxes to everyone across the board and that it may have several trickle-down effects spurring economic growth on national and local levels. Here are some of the main benefits listed out in detail below:
- Only earnings are taxed: Dividends, savings interest, and investment capital gains or increases in value aren’t subject to tax in a pure flat tax system. As a result, taxpayers may be encouraged to invest and save rather than just spend.
- Makes taxes simple: By simplifying the tax code, it’s easier for US taxpayers to be in compliance.
- Economic growth: Advocates of a flat tax rate system claim that a flat tax rate system encourages economic growth. In part because it doesn’t penalize high-earners.
- Reduced need for IRS: Some proponents of a flat-rate tax system have suggested it would partially eliminate the need for the Internal Revenue Service since it would simplify the tax code.
- Eliminates extra taxes: Dividends, interest and other forms of wealth are excluded from being taxed.
- Self-employment taxes: If you are self-employed, you end up paying more in taxes than you would compared to someone within a traditional company. That’s because you pay the full required percentage of Social Security and Medicare taxes that an employer usually pays. A flat tax eliminates this penalty for self-employed workers.
- Promotes local spending: For every $100 that’s spent at a local store not owned by a national chain, $68 of the money stays in the local area. The flat tax can potentially create some disposable income for taxpayers to put back into their local economies.
What are the drawbacks of a flat tax system?
Opponents of a flat tax system argue that it puts too much pressure on the lowest earners while creating loopholes for the wealthier taxpayers— giving them a way to avoid paying their fair share and giving some of those high-earners a significant tax cut.
Below are the possible drawbacks of a flat tax system:
- Places a larger tax burden on low-income earners: Since a flat tax applies to everyone, the wealthy will pay the same amount of taxes as lower earners. Critics argue that this isn’t fair to those who may be struggling but have a bigger bite taken out of their income comparatively.
- Eliminates tax revenue from the wealthy: Because a flat tax only applies to earned income, taxpayers’ funds from investment gains and dividends would not be taxed. In an extreme case, someone could potentially earn enough money through interest and dividends only and owe $0 if they aren’t employed.
- Removes behavioral tax incentives: There are certain tax credits that encourage desired behavior. For example, taxpayers can get a tax credit for donating to charity or purchasing an electric vehicle. If a flat system is introduced, those incentives will not exist anymore.
- Matched retirement income issue: If a company offers a 401k match, that could potentially be considered earned income in a flat tax system. As a result, this may increase many households’ tax burden.
- Adds to the national deficit: Some economic experts think that the current flat-rate proposal would lead to a larger national deficit due to lost tax revenue.
Flat Tax Takeaways
Although there has been no national flat tax rate proposed at a national level recently, this may change in the future. While flat taxes do create the opportunity for simplifying the tax code so more taxpayers are in compliance, they may end up placing a larger burden on low wage earners while higher earners would see a tax cut.