During the leadup to the Budget, the term ‘flat tax system’ was bandied about in Australia and overseas. The Economist gave the idea a run pointing to Eastern European countries that tax personal and corporate income at a common flat fate ranging from 13 per cent (Russia) to 26 per cent (Estonia) applied to all incomes with no deductions. A further nod to neatness (with no real basis in tax theory) is to set the rate of Value Added Tax (that is, GST) at the same rate as personal and corporate income tax (reader Joff Lolliot alerted me to this and some other points covered in this piece.)
Not surprisingly, I’m unimpressed by the concept and the arguments put forward in its support.
The first point that must be noted here is that the income tax in these systems is not really a flat-rate tax, since, as in Australia, income below some minimum threshold is exempt from taxation. Thus, a more accurate description would be “single rate with threshold exemption”.
The distinction is important because, once a tax-free threshold is allowed, the incentive to spread income across a number of family members, inherent in any progressive system but not in a truly proportional tax system, reappears.
A third important point relates to the idea of excluding deductions. Although this sounds attractive, it would be ruinous if it was applied literally to business incomes. A retailer who had to pay 26 per cent tax on gross sales, with no deduction for the cost of goods or for staff wages would be out of business pretty quickly.
So the “no deductions” concept cannot mean what it first appears. Rather, some costs incurred in earning an income must be deductible. One interpretation would be to allow all such costs but exclude other deductions, for example, those for charitable contributions. Obviously this would reduce on charitable giving and similar tax-subsidised expenditure. The bigger problem, though, is that it is the income-related deductions that are important, both as regards revenue costs and as regards complexity of the system.
It seems more likely that advocates of a “no deductions’ system have in mind a system in which companies (and perhaps self-employed personal taxpayers) can deduct expenses, while wage-earners cannot. In this case, the incentive to avoid tax through corporate structures is actually enhanced.
I’ve saved the biggest objection until last. The discussion so far has been about income tax, but what matters for incentive is the tax and welfare system as a whole. Any given set of taxes and welfare rules creates an effective marginal tax rate, given by the combined impact of income, payroll and consumption taxes and clawbacks of means-tested welfare payments.
It’s well known that the highest effective marginal tax rates are typically faced by low-income families, not by high-income individuals. In fact, the tax-system as a whole produces an effect not that much different from a single-rate tax with a threshold exemption. The best way to fix incentives is to address the ‘poverty traps’ created by high effective marginal tax rates, not to eliminate progressivity at the top of the scale.