Tax refers to a levy or a financial charge upon an individual or any other legal entity i.e. a nonhuman entity regarded by law to have the status of a natural person such as a legal name and rights. This levy is normally imposed by a government, or the function equivalent of a government and failure to pay this levy is punishable by law. Taxes may be paid in the form of money or in some cases as labor and mainly consists of direct and indirect taxes. Direct taxes refer to a form of tax paid directly to the authorities or the government by the persons on whom it has been imposed. Indirect tax, on the other hand, refers to a tax collected by an intermediary, such as a retailer, from the individual who bears the eventual economic burden of the tax, such as a consumer. The intermediary then documents a tax return and forwards the tax proceeds to the authorities or government with the return.
Flat tax rate is a term used to refer to a tax system with an unvarying tax rate. Flat tax is tax charged against a commodity or service, for example, a tax on bread of 2 cents per every loaf. It mainly refers to household income that is taxed at one marginal rate and does not vary with parameters such as usage levels or income. Flat taxes have been used to increase compliance and cut on administration costs due to the simplicity offered in the tax code.
There are several main categories of flat tax which differ in how they measure and define what is subject to the stated tax (Simon, 1998). A true flat rate tax is one of the categories of flat tax, and refers to a system of taxation where one rate of tax is applied to all incomes with no exceptions or exemptions. Under this system, no industry or household is subject to preferential treatment, and the cost of tax administration for the government, as well as the cost of tax filing for citizens, is further reduced. However, critics of this system argue that the level of taxation rate for the poor should be reduced as they spend their income on vital goods and services necessary for survival unlike the rich who spend the majority of their income on luxurious goods and services.
Another category of flat tax is the marginal flat tax. Under this system, deductions are allowable, with progressive tax being imposed on a household’s income up to a certain maximum amount, and at this point, the rate of tax on all additional income becomes constant. The major difference between a marginally flat tax and a true flat tax is that there are certain kinds of funds in a marginally flat tax that are not defined as income and are, therefore, not taxable. In this case, income includes salaries, wages and pensions while excluding all other sources of capital gains and other sources of wealth appreciation.
Hall-Rabushka is another type of flat tax based on consumption i.e. spending on goods and services. This tax system accomplishes a consumption tax effect by taxing the household’s income and then excluding any form of investment. Negative Income Tax is another type of flat tax which also deals with personal deductions but in this case, when the deductions exceed the income earned, rather than being set to zero, the taxable income is allowed to be converted into a negative. The rate of flat tax is then applied to the resultant negative income which results in a negative income tax. This means that, unlike the usual positive income tax where the household owes the government, the government owes the household instead. This system of income was proposed by Milton Friedman, an American economist, and was intended to benefit low-income households (Friedman, 1962). However, critics of this system argue that households owing negative tax would be receiving a type of welfare without even having to try obtaining employment.
There are several difficulties faced in devising an effective flat tax system with the principal ones being identification of deductions and how to deal with income. A good example of such problems arises in deciding if the interest charged on loans should be deducted from the taxable revenue of the borrower since the lender is in-turn taxed this interest as income. Rather than creating several ministries to implement social policies such as low-income housing, governments encourage such policies by use of taxes, i.e. they are normally treated as deductions when calculating taxable income. Such policy systems may be curtailed in a true flat tax system, a system which does not involve deductions and can as well remove tools for adjusting the monetary policy of a country (Daniel, 2005).
There is difficulty in eliminating deductions in flat tax since they affect the “flatness” in the tax rate. For example, if businesses were not allowed to deduct expenses from their gross income, then those businesses with a profit margin lower than the flat tax rate could never make any money since the tax imposed on revenues would always go beyond their earnings. The implementation of deductions will, therefore, adjust the effective total tax, and thus the flatness of this tax system. Since tax increases affect all taxpayers, a positive effect of the flat tax system would be decrease or discourage government spending. In order to achieve this, every new government program would have to be cautiously scrutinized which would result in a more efficient government in the long run.
As seen, a flat tax rate system would affect the individuals, government, as well as the overall structure of the economy of a country. The implementation of a flat tax would boost tax revenues by simplifying the tax code and eliminating the many loopholes presently exploited to pay less tax as they are easily spotted and eliminated under the flat tax system than under the progressive tax system. If the flat tax system could be targeted at income, it could equally place the tax burden on all earners rather than other forms of taxes which result in those with lower incomes having to pay a larger proportion of their total income in taxes than the wealthy do.
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