With Tax Day upon us, it’s time to reflect and create a better tax system. The one we have now—the Internal Revenue Code—is a complicated failure that hinders America’s growth while allowing the politically well-connected to get special breaks that are not available to average workers and businesses. This corrupt mess should be ripped up and replaced by a simple and fair flat tax.
The major features of a flat tax are:
- A Single Flat Rate. Instead of tax rates that punish people for contributing more prosperity, the flat tax has one low tax rate for everyone. This minimizes the tax penalty against productive behavior, such as work, risk taking, and entrepreneurship.
- Elimination of Special Preferences. The flat tax would get rid of provisions in the tax code that give special treatment to certain behaviors and activities. Getting rid of deductions, credits, exemptions, and other loopholes will significantly reduce corruption in Washington.
- No Double Taxation of Saving and Investment. The flat tax would eliminate the tax code’s bias by ending the double taxation of income that is saved and invested. This means no death tax, no capital gains tax, no double taxation of saving, and no double tax on dividends.
- Family-Friendly. The flat tax does have a “loophole.” Households receive a generous exemption based on family size. This protects the poor from being taxed. And there’s no marriage penalty, unlike the current system.
The flat tax means radical simplification. Instead of the hundreds of forms needed to enforce the current system, a flat tax requires just two postcard-sized forms. Labor income is taxed on the household postcard and capital income is taxed on the business postcard. For households, each family would report wage, salary, and pension income on Line 1, which should be easily available from W-2 forms. Using Lines 2–5, the household then would calculate its personal allowance, which is based on family size. The personal allowance is then subtracted from income to determine taxable income, which is reported on Line 6. The amount of tax is calculated on Line 7. This amount is then compared to the amount of tax withheld on Line 8, which then leaves either a tax payment (Line 9) or a refund (Line 10).
This postcard is so simple that a third-grader could file a family’s tax return in about five minutes – in part because families do not need to worry about reporting dividends, interest, and other forms of capital or business income. Those forms of income are taxed using the business postcard, which is equally simple and transparent. Total revenues go on Line 1. Businesses would then add together their wage costs, their input costs, and their investment costs on Lines 2 and 3. These costs are subtracted from gross receipts to determine taxable income on Line 4. Line 5 is the amount of tax that is due. Lines 6–10 only exist in case a company has losses to “carry forward” from one year to another.
There are two principal arguments for a flat tax—growth and fairness. Many economists are attracted to reform because the current tax system is so anti-growth, with its high rates, corrupting loopholes, and discriminatory taxation of saving and investment. A flat tax would not eliminate the damaging impact of taxes, but it would boost the economy’s performance compared with the present tax code. This is why the 25 places with flat taxes, ranging from Hong Kong to the Czech Republic, are enjoying better economic performance.
The most persuasive feature of a flat tax for many Americans however, is fairness. The 1000-plus documents, instruction manuals, and forms that comprise the internal revenue code are a nightmare for regular people, but they’re a gold mine for the lobbyists, politicians, and special interest groups. This maze of credits, deductions, preferences, loopholes, and exemptions gives a big advantage to those who wield political power and can afford big-time lawyers, lobbyists, and accountants.
The class-warfare crowd doesn’t like the flat tax because they want to punish the rich with high tax rates. But they are missing the point. The flat tax isn’t designed to help the wealthy. It’s designed to make it easier for the rest of us to become better off. Some investors and entrepreneurs will pay lower tax rates, but a lot of rich taxpayers will pay more since they’ll lose access to all the loopholes and tax shelters. If Bill Gates makes 100,000 times more money than I do, he should pay 100,000 times more in taxes.
The current income tax system punishes the economy, imposes heavy compliance costs on taxpayers, rewards special interests, and makes America less competitive. A flat tax would dramatically reduce these ill effects. Perhaps more important, it would reduce the federal government’s power over the lives of taxpayers and get politicians out of the business of trying to micromanage the economy.
Daniel Mitchell, Ph.D., is a senior fellow at the Cato Institute.