Should The U.S. Switch To A Flat Tax?

Investing News

The only guarantees in life are death and taxes. But out of those two, one is infinitely more complex than the other.

In America, that becomes clear every April, a month associated with the cold sweats that routinely come when individuals and families rush to file their taxes on time. It’s a stressful process that can involve long hours, finger blisters from calculator mashing, angry phone calls to human resource offices and expensive checks written to accountants.

Residents in many other countries around the world face similar circumstances. This is because, like in America, most of the world’s major economies have a gradual tax system that charges different rates for various income levels. In most cases, those who make the most money pay a higher percentage in taxes compared to lower-income brackets.

But some countries use a completely different tax system, and it’s one that some pundits would like to see advance around the world.

Key Takeaways

  • A flat tax is a system where everyone pays the same tax rate, regardless of their income.
  • While countries such as Estonia have seen their economies grow since implementing a flax tax rate, there’s no actual proof that the tax system is the reason behind the growth.
  • Some drawbacks of a flat tax rate system include lack of wealth redistribution, added burden on middle and lower-income families, and tax rate wars with neighboring countries.

What is a Flat Tax?

What is a Flat Tax?

In many nations, governments have chosen to charge residents and businesses a flat tax. In other words, everyone pays the same exact rate. Proponents of flat taxes say that several benefits exist from using this system.

Many of the countries that have shifted to a flat tax were at one time in the Soviet Union. And these countries, for most of the past decade, have seen their economies grow rapidly. In 2004, 10 Eastern European nations used a flat tax: Ukraine taxed its residents 13%, Georgia implemented a 12% tax, and Romania taxed its citizens 16%. and Lithuania taxed its residents 33%. And many of these countries that instituted a flat tax saw their economies grow dramatically.

For example, Estonia, Lithuania, and Latvia were suffering from inefficiency and economic stagnation prior to implementing flat taxes of 26%, 33%, and 26%, respectively—and experienced unprecedented growth following the tax reform, over double what was seen in the world’s mature, industrialized economies. Estonia experienced an average growth of 9% each year (adjusted for inflation); Lithuania emerged as the fastest growing economy in the Baltics; and Latvia experienced an average growth rate of about 4% a year since the flat tax, and its inflation, which was 25% in 1995, dropped to less than 4 %.2 a by approximately 8% in a single year.

The reason why the flat tax works, according to proponents, is that the system is incredibly simple. In many cases, it’s not just individuals who enjoy the benefits of an easy-to-understand tax code; some nations grant flat taxes to businesses as an incentive to lure corporations and other employers. In addition, there’s an inherent sense of fairness to the flat tax, as all people pay the same percentage of their income. This also de-politicizes tax codes as they are written since legislators cannot give preferences or penalties to firms and industries they look upon either favorably or negatively.

Working Proof

Flat tax supporters often cite the nation of Estonia as proof of the system’s benefits. Pinned between Russia and the Baltic Sea, Estonia is a tiny country with under two million residents, roughly the size of Dallas, Texas. In 1994, just three years after separating itself from the Soviet Union, Estonian policymakers made the choice to go to a 26% flat tax, the first in the world to move away from the gradual system. That number since then has been reduced to 20%.

Since instituting the flat tax, Estonia has emerged from obscurity to become a member of the European Union. And it has also earned the nickname “The Baltic Tiger” due to its incredible economic growth rate. From 2000 to 2008, Estonia’s economy grew by an average of 7% per year. Though hurt by the global Great Recession, it had rebounded to 4.9% by 2017. In 2011, its unemployment rate was in excess of 13.5%; in 2020, only 6.9% of its population was without jobs. Estonia has also gained a reputation for being surprisingly high-tech; over 89% of its population uses the internet, well above the world average.

Other nations followed Estonia’s lead and also adopted flat tax policies. First on board were Estonia’s two Baltic neighbors, Lithuania and Latvia. Next came Russia, the biggest economy to have adopted this measure. Also following suit were Serbia, Ukraine, Slovakia, Georgia, Romania, Kyrgyzstan, North Macedonia, Mauritius, and Mongolia.

So, Why Not Move to a Flat Tax?

First, while there is no doubt that many countries that have adopted the flat tax have had booming economies, there is no actual proof that the flat tax is the reason why these nations have grown. After all, many of these places were Communist nations behind the Iron Curtain. Once the Soviet Union collapsed they were able to open up their economies to investment and had an easier time trading with the developed countries in the west.

In addition, a flat tax may not be as fair as one would think. A gradual tax system does allow for things like wealth redistribution, which many have argued is a major benefit to society. And a flat tax could also give middle-class families an extra burden. If someone making one million per year has to pay 18% of his income in taxes, he still has netted $820,000 for the year, a figure which still has great purchasing power. But a person making $50,000 per year is left with $41,000 per year; that difference can influence fiscal decisions, like purchasing a new car versus a used car, whether to place a down payment on a house or affording either a state school or private college, extremely tough for people who make closer to the national median income level.

In addition, when a group of countries near each other enact a flat tax, it creates a race towards the bottom; in order to compete, nations must keep on lowering their tax rates, a problem that could lead to fiscal instability.

Lastly, in the wake of the 2008 recession, many countries that adopted a flat tax have suffered greatly. Take, for instance, Latvia, one of the earliest countries to adopt the flat tax. Its overheated economy suffered a near-complete liquidity squeeze, which caused its GDP to decline approximately 25% between 2008 and 2010, and unemployment to climb to nearly 21% of the population. It had to take a bailout from the International Monetary Fund in order to pay public sector workers.

The country recovered but decided to ditch the flat tax on personal income in 2017. It now has a progressive system with rates rising from 20% to 31% as a taxpayer’s income increases.

Latvia’s Baltic neighbors, Lithuania and Estonia, also faced similar pitfalls during the global Great Recession. All of this, some say, is a sign that these nations failed to raise enough tax dollars due to their tax policies. Others, however, say that these nations rely on exports, which suffered greatly due to the downturn facing major economies.

The Bottom Line

So, will the entire world one day have a flat tax? It’s unlikely, especially in the world’s biggest economies which have a long-established tax code that many might not want to change. But it is likely that, despite recent pitfalls, many smaller and growing nations may see the benefits of charging everyone the same tax.

Correction—Nov. 22, 2021: This article previously misidentified the country of North Macedonia.

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