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[1] 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.
John Quiggin 
John, did you happen to read Economist’s survey of Australia in the current issue?
Their proposed prescription for what ails Australia is tax cuts and deregulation of the labor market. Of course, their cure for all problems is tax cuts and deregulation, so no shock there.
But one claim that caught my eye was a claim that, and I quote “Unlike households, businesses have used the fat years to pay down debt, so if further rises in interest rates aer needed, they will do little to hurt employment.” Are they serious?
“In this case, the incentive to avoid tax through corporate structures is actually enhanced.”
Suppose that you were to say to the University of Queensland, I don’t want you you to employ me anymore, I want you to buy the services of John Quiggin Pty Ltd so I can make all these tax deductions.
I’d be surprised if they’d agree. And even if they did, the tax office could get you under the alienation of personal servicves income rules.
I’m not sure that your arguments about deductions leading to people using companies to avoid tax is neccesarily true in practice.
The flat tax system (for the 1/3 of workers that have to pay tax) in Hong Kong seems to work fine (although I doubt would work in Australia), despite almost no deductions being available to wage earners — and the goverment certainly doesn’t complain that people are using companies to get around paying personal tax. One might therefore suspect the problem of using companies to avoid tax is worse in Australia (where the government does complain about it), although I know of no comparitive figures.
I don’t believe that Hong Kong has a flat tax system. Workers pay standard progressive marginal tax rates with deductions, with a celing of 16% of total income. Apparantly only the top 1.5% of workers qualify for that “flat-like” 16% rate.
(see http://mediamatters.org/items/200501270004 and http://atrios.blogspot.com/2005_01_23_atrios_archive.html for more detail)
PrQ,
I believe you have not given a flat tax system enough thought (on the other had, I may have given it too much), but I believe your objections can be overcome.
To counter your first point, as opposed to most of these systems as enacted, I believe a true flat rate tax (i.e. no minimum) can be a viable option, as outlined below.
I cannot seem to locate your second point.
Your third [sic] point can IMHO be dealt with by looking at corporate taxation another way. Corporate taxation is simply personal taxation brought forward. Ignoring (for a moment) the external sector, all corporate profits end up in shareholders hands in the end – corporate taxes are, therefore, just a mechanism for bringing forward personal taxes. If all corporate taxes are dropped there would be an immediate reduction in total tax paid, but this would only be a short-term outcome until the dividend rate changed to reflect the increased profits.
This eliminates the problem of the incentive to set up corporate structures to get around the tax system at a stroke. You can deduct anything you want, but it makes no difference. Any drawings in any way from the company become taxable income, to be taxed at the flat rate.
The introduction of the external sector (overseas income, payments) becomes a small problem, but this can be countered in several ways. One would be to simply tax only income earned in Australia, by whoever earns it, at the same rate. The other options include taxing only income repatriated and not payments made out of the country or to tax all income by Australian residents, regardless of where it is earned but not income earned by overseas residents.
The first option has the beauty that, for most income earners, the income tax could be replaced by a payroll tax, greatly simplifying the administration of the system.
On your fourth point, now that the high marginal tax rates at the bottom of the scale no longer exist, benefits for the disadvantaged can be done by a reasonably simple scheme, somewhat akin to the negative income tax proposed many years ago.
The system would then become many things the current one is not – simple, clear and inexpensive, both to comply with and to administer. The amount of tax accountants that could be put on to useful work would alone be large.
To me, the current ‘system’ is a disgrace. The fact that the ITAA is now several times as large as “War and Peace� and is many times more difficult to read and understand means that tinkering with the marginal rates , deductions etc. is now no longer an option. The thing that really scares me is that, at law, we all fully understand it. We need to replace it and I think that this is one possibility that can and should be studied.