What is a Flat Tax? (Surprise, it is a VAT!)

By :: October 24th, 2011

Rick Perry is reportedly going to announce his tax reform plan, a so-called flat tax. There are, as far as I know, no details about the rate or exemption level of the tax or whether it will allow deductions for things like charitable contributions or mortgage interest.  So I can’t comment on the specific proposal, but I can try to dispel some misconceptions about the flat tax.

What is the flat tax? The flat tax is a VAT, not so different from the taxes popular around the world. Under one variant of VAT, called a “subtraction-method VAT,” businesses deduct the cost of inputs from gross receipts and pay tax on the difference—the value added. It is basically a sales tax where the tax is collected in stages from each producer on the supply chain rather than all at once from retailers (as in the retail sales taxes that are common in the US). A flat tax adds one more wrinkle:  businesses are allowed a deduction for wages paid, but the employees pay the “flat tax” on their wages directly. If that’s all that happened, the tax burden would be identical to the VAT (assuming the same level of compliance), but the flat tax also allows an exemption for every worker.  Wages are only taxed above that exemption level, typically set at around the poverty level, so that wages up to the poverty threshold are exempt from tax.

How would a flat tax affect low- and middle-income households? A flat tax would be much more regressive than the current income tax. For one thing, it’s unlikely to include the refundable tax credits (like the EITC and child credit) that augment the earnings of low earners. It’s not impossible to add refundable credits, but I’ve never seen them in a flat tax proposal. As a result, poor people will pay a larger share of their income than they do at present. Middle-income people will also pay more.

Moreover, spending falls as a share of income as income rises. Low-income people spend all their income or more.  High-income people spend only a tiny fraction.  (See chart.) A VAT or flat tax inevitably exempts most of the income of high-income people from tax. If it is going to raise the same amount of revenue as the current system, it must raise somebody else’s taxes.  That would be low- and middle-income people.

I am implicitly assuming that a VAT or flat tax would translate into higher prices--i.e., consumers would bear the brunt. Eric Toder, Jim Nunns, and Joe Rosenberg of the TPC argue that the burden should instead be allocated to labor and capital. I think the right answer lies in between, but however you slice it, the tax would be pretty regressive.

Of course, Rick Perry has expressed “dismay” at the low tax burdens on lower-income people. The flat tax is a perfect way to fix that.

Other countries have national VATs. Why would this be a big deal? VATs in Europe and the rest of the world supplement national income and payroll taxes. Often the flat tax is proposed as a complete replacement. Nobody has done that to my knowledge.

Huh? Flat taxes are widespread in Eastern Europe and Russia. Yes, so-called “flat taxes” are common on Eastern Europe and Russia, but they’re flat rate income taxes. They include capital income, such as interest, dividends, rents, and royalties in the base as well as wage income. Because high-income taxpayers receive most of the capital income, this makes those flat taxes more progressive than the flat tax periodically proposed in the US. (For example, it was the centerpiece of Steve Forbes’s presidential bid. Forbes just endorsed Perry.)

Wouldn’t a flat tax be super simple? A really comprehensive flat tax would be simpler than our current system because there would be no deductions or credits, and only the one exemption.  But our income tax would also be much, much simpler under those circumstances.  It’s true that calculating tax when there’s only one rate is simpler than calculating tax when there are multiple rates, but most people look up their tax in a table or use software or a paid preparer so the value of this simplification is also pretty negligible.  Since capital income (interest, dividends, etc.) would be exempt from tax, that would simplify reporting and recordkeeping for most taxpayers.  Overall, a flat tax would be somewhat simpler than a similarly comprehensive income tax. But the same pressures that make the current tax system riddled with deductions and credits would apply to the flat tax. It is not clear that it could stay pristine.

Could the flat tax be made more progressive? Yes. There’s a variant of the flat tax, called the X-tax, which has a progressive rate schedule and can be much more progressive than a single-rate tax. This tax was invented by the late Princeton economist David Bradford, who favored moving to a consumption tax base but worried about the regressivity of a flat tax or VAT. In theory, at least, it would be possible to match the progressivity of the current income tax by including a refundable tax credit like the EITC and steeply progressive tax rates. However, top tax rates would have to be very very high. (See the chart above.)

If you’re interested in a more positive take on the flat tax, look at the Flat Tax page on the Hoover Institution website. It includes an update of Hall and Rabushka’s book available in pdf format.

An earlier version of this post was on my Forbes blog, The Impertinent Economist.

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  1. Matthias  ::  6:18 pm on October 24th, 2011:

    It’s worth pointing out that many VAT proposals (the much talked about “Fair Tax” for instance) include a refund for low income households. For example, a family of 4 would get a refund (or, as they call it, a prebate) for up to $29,420 worth of spending.

    This would reduce the taxes paid by the lowest two quintiles to nearly 0%, making it much less regressive tax.

    It seems to me that you should update your charts to reflect this.

  2. NCDAD  ::  8:23 pm on October 24th, 2011:

    I think that whatever atx reform is done, they need to take away the tax break on children. It encourages people to have children that can’t afford them just so they can get the tax break and then get on welfare programs. It also encourages people to become foster parents for all the wrong reasons.

  3. steve  ::  10:12 pm on October 24th, 2011:


  4. Michael Bindner  ::  10:37 pm on October 24th, 2011:

    The other varient is a VAT-like net business receipts, which would not require individual filing like the flat tax, but could include lower rates or distribution of tax beneifts to lower wage workers and higher rates for dividends and higher income workers. The only problem with this approach is a lack of visibility of taxation and the possibility that some high income earners would slip through the cracks, while lower income heirs and investors may be over-taxed. Leaving a separate income tax in place for high earners avoids this problem and the alternative solution, which is having to report all your information to everyone if you have dividend or high income.

  5. Jack B  ::  7:41 am on October 25th, 2011:

    Flat Tax is a VAT?
    I was under the impression that what made a tax flat was paying the same tax rate across an entire range as opposed to a progressive tax where percentage changes at different ranges. How does a flat tax go from an income tax to a consumption tax which is what a VAT is, because we call it flat. Couldn’t we have a flat income tax?
    I think we are getting into a confusion of terms.

  6. John S  ::  8:55 am on October 25th, 2011:

    I don’t think the data on fertility in this country supports the effect of the child tax credit claimed by this comment. Most birth rates have declined or leveled off since the tax credit went into effect. (see Census data at http://www.census.gov/compendia/statab/2011/tables/11s0083.pdf.) However, I would be curious to see if anyone did real research on this (beyond just my casual glance at Census data).

  7. Brian Dell  ::  9:17 am on October 25th, 2011:

    The biggest political obstacle to flat taxes likely remains concerns about distribution effects, but on this point it would be noted that California’s tax system is quite progressive, both re income tax brackets and re taxes on capital gains, yet the Golden State is still something of a fiscal mess and they have big problems with the volatility of revenues collected by this “soaking the rich”. All’s fine in 1999 at the top of the dot com bubble but in a downturn they have big revenue problems. Flatter taxes like those discussed here would help mitigate this volatility.

  8. Stuart Greenfield  ::  12:16 am on October 26th, 2011:

    It would appear that my governor would like the federal tax system to be more like the regressive Texas tax system, http://www.window.state.tx.us/taxinfo/incidence/96-463TaxIncidence02-11.pdf

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