The Economic Perks of Flat Taxation
Kahill Sarronwala takes a look at some of the economic benefits of a flat tax while distancing the concept from any political baggage.
Taxation has always been a sensitive political and economic topic. In particular, the notion of a flat tax has long been propagated by fiscal conservatives. A flat tax would impose a consistent rate of income taxation for all, save the lowest income earners. It is unfortunate that the political source of support for a flat tax has coloured the concept of the tax and to a large extent, obscured its benefits. This piece will seek to argue that a flat tax can sport numerous benefits; including simplicity, the removal of tax loopholes, and immense economic perquisites.
A Question of Fairness
Let us begin by discussing one of the strongest arguments against a flat tax. Notable economic commentators have argued that a ‘fair’ taxation system is one which makes the paying of taxes ‘equally’ painful for everyone. A flat tax is incapable of doing this because the value of money is relative to each individual. Thus, if we imposed a flat tax of 10% for example, then an individual earning £20,000 a year will pay £2000 in income tax, and have £18,000 to live on. In contrast, an individual earning £100,000 a year will pay £10,000 in income tax and still have £90,000 to live on. Essentially, this means that as a person increases their income, each individual Pound will become subjectively devalued and marginal utility will decrease. Therefore, a flat tax hits those with a lower income harder, and fails to appreciate that money has a different value at different levels of income. This is why proponents of such an argument will often support a progressive taxation system, intended to embody this ‘relative value’ argument. To elaborate, we should observe that a progressive taxation system is attempting to estimate levels of essential and disposable income and tax accordingly.
However, I submit that despite the noble and equitable sentiments of this view, there are several flaws within this argument. Firstly, the argument itself identifies the value of money as being subjective, making the ‘relative value’ of money difficult to define. Yes, someone with a lower income may value each Pound they make more than someone with a higher income. Yet, take two people of equivalent income; one was born into privilege and had the resources and connections to become successful, whereas the other came from an underprivileged background and had to work harder in order to reach the level they are at. The second person may have a greater subjective value for money, but even according to a progressive taxation system, the ‘relative value’ of money would not be appreciated between the two people. A progressive taxation system only looks at quantitative variations, but attempts no further nuance, insofar as qualitative variables are concerned. A taxation system simply cannot take account of the millions of variations within a population which base an individual’s relative value for money. A corollary of this argument is that it would be far too difficult to design and implement a tax system which is able to take an account of the subjective value of money and the precise decrease in marginal utility.
Secondly, this argument fails to recognise that a flat tax can still attempt to be set at a rate which attempts to achieve a balance between the rich and poor. In addition, the flat tax would simply not apply to those on the bottom rungs of the ladder (however, we will observe that there is a degree of uncertainty as to what level this should be set at; this is arguably the most contentious part of a flat tax). Moreover, as with the Hong Kong model,[1] it is still possible for certain deductions such as charitable donations, dependent care, and home loan interest to remedy certain inequities. This is not to say that the ‘relative value’ argument does not have merit. Rather, it identifies a problem with a flat tax but fails to lead to an adequate and precise solution to it. Therefore, although the argument has some merit, we cannot allow it to obscure the other economic benefits of a flat tax.
Simplicity
Progressive taxation systems bring with them an intrepid maze of regulations, rules, and as many exceptions. France, for example, contains close to 600 different types of tax relief.[2] The US tax code spans over ten million words and suffers from the same deficiencies as the French system.[3] The UK has seen its tax regulations more than double over the past twenty years.[4] Modern tax codes are far too complicated and nebulous; this results in increased costs for parties determining the exact amount of tax to be paid. Complexity is not intrinsically bad, but it can be. Take employment status, you have a set of 'employees' and a set of people labelled as freelancers within one organisation. Different deductions and allowances are in play due to the individual contractual arrangements, pension scheme structuring and deductions, and the method of tax payment. Now, suppose HMRC mounts a tax challenge against the organisation. This acts as a cost for the state because HMRC will be expending money and time. Additionally, the challenge is made to the organisation who will now need to devote human capital and financial resources to fight the challenge. If litigation ensues, the judiciary will spend time and money trying to interpret whether and how any tax liability exists. A second logical fallout stems from the fact that most people are not experts in tax law. The average individual is unlikely to understand what deductions and exemptions are available. As a result, people overpay and underpay often, which leads to direct financial costs for either the individual or HMRC if left unchallenged. It also represents a financial cost to both parties if there is a challenge and a lost opportunity cost if a challenge is successful either way.
Furthermore, with the innumerable exceptions and loopholes, such codes inevitably create inefficiencies in tax collection processes. To an extent, the maze of tax regulations and loop-holes distorts economic incentives, and in a sense, allows tax evasion and avoidance.
A flat tax is simple and clear. Transparency would naturally increase; reducing the incentives and the ability of higher-income earners to avoid tax by using tax shelters and clever structuring. More people would likely pay more tax correctly with a flat tax system. For example, in 2001, Russia implemented a 13% flat tax. Revenues from personal income tax rose by a staggering 26% a year later, 25% a year after that, and 15% in the next year.[5] This is because the risk of being prosecuted under a flat tax is much higher due to the non-existence of hundreds of loopholes. So, by being disincentivised by the risk of breaking the law, and being incentivised by a relatively low flat tax rate, more people paid their taxes. However, we should take such data with a pinch of salt, as this does not guarantee that a flat tax would be as successful in other parts of the world. This is because, in Russia, the increased tax payments were largely due to many people stepping out of the shadow economy. In places like the US or UK, where the shadow economy is much smaller, we may not see such a large increase in tax revenues.
With regards to the costs of complicated tax systems, Germany currently spends close to 4 billion Euros, accounting for around 0.11% of Germany’s GDP, on processing and collecting tax.[6] A flat tax system would see the reduction of tax authorities and bodies. Money could, therefore, be reallocated to welfare and infrastructure.
Investment and Government Revenue
As we have observed, a flat income tax would mean that governments would spend less on accounting and collection, save on tax infrastructure, and overall tax revenues would rise as more people pay the taxes they owe. The flat tax also has the potential to attract increased foreign direct investments.
In 2004, Slovakia scrapped its category taxation system, along with tax brackets, exemptions and deductions. A flat tax of 19% was adopted instead. As a result, Hyundai Corp. invested close to $1.2 billion in the city of Zilina.[7] This created immense opportunities for employment within the city. We can further observe a trend of increasing foreign direct investment since the introduction of a flat tax. As multinationals and sovereigns participate in foreign direct investment, it signals to the rest of the world that the investments are worth making. Thus, perpetuating further investments which can contribute to the growth and development of the country. We should note that despite this, there are still issues surrounding the enhanced redistributive aspects of a progressive tax when compared to a flat tax.
To conclude, a flat tax is desirable for many reasons, and we should acknowledge the potential of its implementation. We should aim to segregate taxation systems from the political ideologies, which are so closely linked to them. In doing so, we may achieve immense growth and development for both developing and developed countries.
Written by Kahill Sarronwala.
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[1] Reynolds, Alan. (2001). Hong Kong's Modified Flat Tax - A Model for the U.S. 10.13140/RG.2.2.22121.39529.
[2] Victor Thuronyi, Tax Law Design and Drafting, volume 2; International Monetary Fund: 1998, Chapter 14, Individual Income Tax
[3] E.R.A. Seligman, American Economic Association Quarterly, 3rd Series, Vol. 9, No. 4 (Dec., 1908), pp. 1-334
[4] https://www.instituteforgovernment.org.uk/news/latest/uk-tax-system-needs-urgent-reform-under-any-government
[5] https://voxeu.org/article/effects-russia-s-flat-tax
[6] https://www.diw.de/sixcms/detail.php?id=diw_01.c.421801.de
[7] M. Jakubiak and P. Kolesar, Centre for Social and Economic Research, Car industry in Slovakia, recent developments and impact on growth