Like in the U.S., 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, or a flat tax system in which everyone pays the same rate. Should the U.S. switch to a flat tax system? Review the potential pros and cons for both sides.
Key Takeaways
- A flat tax is a tax system in which 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, some say there is no proof that the tax system is the reason behind the growth.
- Some drawbacks of a flat tax rate system include lack of wealth redistribution.
- A flat tax may impose an added burden on middle and lower-income families or trigger tax rate wars with neighboring countries.
What Is a Flat Tax?
In many nations, governments have chosen to charge residents and businesses a flat tax so that everyone pays the same exact rate. Proponents of flat taxes tout several benefits such as economic growth and fairness.
Many 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, saw their economies grow rapidly in the following years. 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 significantly.
Note
The reason why the flat tax works, according to proponents, is that the system is easy to understand.
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, proponents say there is a sense of fairness to the flat tax, as all people pay the same percentage of their income. This also helps 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.
Advantages of a Flat Tax
Flat tax supporters often cite the nation of Estonia as proof of the system's benefits. Located between Russia and the Baltic Sea, Estonia has less than 2 million residents, which is roughly the size of Dallas, Texas. In 1994, three years after separating itself from the Soviet Union, Estonian policymakers initiated a 26% flat tax, the first country in the world to move away from the gradual system. Estonia's flat tax is now 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.
Other nations followed Estonia's lead and also adopted flat tax policies including Lithuania, Latvia, and then Russia, the biggest economy to have adopted a flat tax. Serbia, Ukraine, Slovakia, Georgia, Romania, Kyrgyzstan, North Macedonia, Mauritius, and Mongolia also imposed a flat tax.
Downsides of a Flat Tax
While many countries that have adopted the flat tax have had booming economies, critics of the flat tax say there is no proof that the flat tax is the reason for the growth. After all, many of these countries were communist nations. Once the Soviet Union collapsed they were able to open up their economies to investment and could then trade with the developed countries in the West as freer markets.
In addition, critics also say they believe a flat tax is actually unfair. A gradual tax system does allow for things like wealth redistribution, which many have argued is a major benefit to society and more fair.
A flat tax could also give middle-class families an extra burden. For example, if you make $1 million per year and you pay 18% in taxes, you would still net $820,000, which still has great purchasing power. But if you made $50,000 per year, the same tax rate would net you $41,000 per year, which can be a financial strain.
In addition, when a group of countries near each other enact a flat tax, it can create competition to lower tax rates, which could lead to fiscal instability.
Lastly, in the wake of the 2008 recession, many countries that adopted a flat tax suffered greatly. For example, Latvia, one of the earliest countries to adopt the flat tax, 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.
Latvia 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.
How Does a Flat Fax Benefit the Rich?
A flat tax means the rich pay a lower tax rate than they would if the tax system included tiered rates. With much higher income, an individual will feel less of a burden with paying taxes. In contrast, a flat tax on people with lower and middle incomes would be more of a strain their finances.
What Is an Advantage of a Flat Tax?
A tax system with flat tax rates is one that is easy to understand. Some say a flat tax system can lead to economic growth for developing countries.
Which States Have a Flat Tax?
The 13 states that had a flat tax as of 2023 include: Arizona, Colorado, Idaho, Illinois, Indiana, Kentucky, Michigan, Mississippi, New Hampshire, North Carolina, Pennsylvania, Utah, and Washington. New Hampshire's flat tax applies only to interest and dividend income and Washington's flat tax applies to higher earners' capital gains tax.
The Bottom Line
The U.S. has a tiered tax system and, of course, it has opponents who believe a flat tax system has more benefits and fairness. However, it's unlikely the U.S. and the world's biggest economies which have a long-established tax code will change its tax system any time soon. However, smaller and growing nations may see the benefits of charging everyone the same tax rate.
