Flat Tax
Principles and Issues
Executive summary
The issue of tax cuts has overwhelmed the equally important issue of tax reform in the national debate. Further, any discussion of tax reform during the 2000 federal election was riddled with misinformation that effectively prevented an open and rational debate about tax reform. The study outlines many of the issues raised during the recent federal election and provides information on tax reform in order to provide a foundation for rational debate.
Flat tax versus single-rate tax
It is important to differentiate between reform based on a flat tax and the replacement of multiple tax rates with a single tax rate. The later constitutes the type of tax reform implemented in the Province of Alberta in 2001 and proposed by the Canadian Alliance in the 2000 federal election. The replacement of multiple tax rates with a single rate is but one step in the process of broad-based flat tax reform.
Hall-Rabushka flat-tax reform
There are a number of well-known flat-tax proposals but the most discussed is that developed by Robert E. Hall and Alvin Rabushka of the Hoover Institution. It taxes all types of income once and at one rate. In their most recent analysis of the United States, Hall-Rabushka (1995) recommended replacing the five personal federal rates (15%, 28%, 31%, 36%, and 39.6%) and the various business tax rates with a 19 percent federal tax rate for both individuals and businesses.
Simplicity
Hall-Rabushka contains no tax credits, deductions, or exemptions except for the personal, spousal, and child exemptions. In other words, the myriad of tax credits and deductions present in the current system and the attendant complicated and time-consuming paperwork are eliminated. Further, flat-tax reform significantly simplifies the determination of income, which constitutes much of the complexity associated with the current tax system. Hall-Rabushka clearly achieves one of the core criteria of tax policy, namely simplicity.
Equity
Hall-Rabushka is an integrated approach to taxation wherein both business income and personal income are taxed once and only once. This type of integrated approach to taxation achieves horizontal equity, the principle that people with similar incomes should bear similar tax burdens. The personal exemption ensures vertical equity is achieved; that is, as people earn more, they pay more. Thus, Hall-Rabushka achieves both measures of equity, the second criteria of tax policy.
Efficiency
Another benefit of Hall-Rabushka is that it effectively moves the income-tax system away from taxation of income towards taxation of consumption. A consumption tax is levied on any income that is consumed, i.e., spent rather than saved. Economists generally agree that the taxation of consumption is one of the most efficient manners in which to raise tax revenue.1 The exclusion of savings (investments) under Hall-Rabushka effectively creates a tax system based on taxing consumption rather than income2 and, thus, achieves the third of the tax criteria, efficiency.
Other gains
There are a number of other important economic improvements to be gained by implementing Hall-Rabushka. The net economic effect of the reforms proposed by Hall-Rabushka include improved incentives for work, increased entrepreneurial activity, and greater capital formation, all leading to a higher level of national output and standard of living.
Progessivity--why we have multiple rates
We have more than one tax rate in the current system to achieve progressivity, the principle that taxpayers should pay more income tax as a percentage of their income as they earn more. This has been achieved, traditionally, using progressively higher income-tax rates applied on progressively higher incomes.
Evidence regarding the negative effects of high and increasing marginal taxes is strong and growing. For instance, Marsden (1983), Koester and Kormendi (1989), Easterly and Rebelo (1993), Mullen and Williams (1996), Becsi (1996), and Engen and Skinner (1996) all conclude that high and increasing marginal tax rates have negative effects on rates of economic growth. Further, Carroll, Holtz-Eakin, Rider, and Rosen (1998) found that higher marginal tax rates reduce capital formation, a key ingredient in long-term economic growth. This literature, overall, concludes that high and increasing marginal tax rates contribute to lower rates of economic growth, reduced rates of personal income growth, lower rates of capital formation, aggregate labour supply that is lower than expected, and reduced social welfare. In short, high and increasing marginal tax rates reduce economic growth by creating strong disincentives to hard work, savings, and investment.
Progressivity without increasing rates
One of the many benefits associated with a flat tax is that it is able to achieve progressivity in the tax system--those earning more pay more in taxes as a percentage of income--while at the same time eliminating the damaging effects of high and increasing marginal tax rates. This is achieved by including a personal exemption in the tax system. In other words, by allowing individuals to earn a certain amount of money tax-free each year, the system incorporates progressivity without incurring the cost of increasing marginal tax rates.3
Flat-tax case calculations
Nine separate flat taxes scenarios were calculated using on Statistics Canada's Social Policy Simulation Database and Model (SPSD/M) with 2000 as a base year.4 The flat-tax calculations in table ExSum1 range from a simple system with no exemptions or deductions to a system with generous individual and spousal exemptions, child exemptions, full RRSP and RPP exemptions, and charitable donation deductibility.
As one would expect, the value of the personal exemption has an enormous influence on the applicable flat-tax rates. The larger the personal exemption, the higher the required flat-tax rates. There is, therefore, a powerful trade-off between the value of the personal (and spousal) exemption and the applicable flat tax rates.
Five households were also analyzed in order to determine the tax effects of the various flat-tax proposals on specific households. The one major trend present in each of the nine flat-tax cases is the equalization of tax treatment for households with similar incomes, regardless of the employment status of the parents. In other words, the implementation of any of the nine flat-tax scenarios presented eliminates the current discrimination faced by two-parent households in which only one parent works outside the home relative to other households with similar incomes but in which both parents work outside the home.
Income dynamics and mobility
The main criticism levied against flat taxes is that they dramatically shift the burden of taxation from high-income earners to low-income and middle-income earners. To a certain extent, this shift in the tax burden is inevitable given the extremely progressive nature of Canada's current tax system. For instance, in 1997, the top 13 percent of tax-filers--those earning in excess of $50,000 per year--earned 40.7 percent of all the income declared to Revenue Canada for tax purposes but contributed 59 percent of all income taxes paid.
This shifting of the tax burden, however, is exaggerated by tax analysis based on a single year, an inappropriate tool for the task. The ability of individuals and households to move up and down the income spectrum demands that longer time horizons be incorporated into tax analysis in order to determine the real, long-term effect of tax changes.
A recent Canadian study found that, over a two-year period, 13.8 percent of households moved up one quintile in the income distribution and an additional 3.2 percent moved up more than one quintile. Put another way, of those households initially in the bottom two quintiles in 1995, 24 percent found themselves at least one quintile higher by 1996. This depicts a fairly dynamic picture of the ability of Canadians to move up the income scale.
The rates of upward income mobility increase significantly when the analysis is extended to cover a five-year period. Twenty-one percent of households moved up one quintile in the income distribution over a five-year period and an additional 8.2 percent moved up more than one income quintile. In other words, a total of 45 percent of those in the bottom two quintiles moved up at least one quintile over the five-year period of the study.
Research into income mobility in the United Kingdom and the United States corroborates the Canadian results. One American study covering a 15-year period from 1975 to 1991 concluded that only one-half of one percent (0.05 percent) was in the bottom quintile for every year of the study. In fact, only 5.1 percent of those in the bottom quintile in 1975 were still in the bottom quintile in 1991.
Another study, covering the period from 1979 to 1998, found that 86 percent of households in the lowest income bracket moved to a higher grouping over the period. Similarly, Census Bureau data for the 1980s consistently shows roughly 20 percent of the people in the bottom quintile moving up a minimum of one quintile within a one-year period. Finally, a 1992 study from the Urban Institute concluded that approximately one-half of those in the bottom quintile during the 1967-1976 period had moved up by the 1977-1986 period.
Such long-term analyses strongly suggest that individuals would gain under any of the nine flat-tax proposals presented above as any initial tax increase would more than be offset by later tax reductions during the individual's peak earning period.
International evidence
Tax systems based on a flat-tax model are not just theoretical abstractions discussed by tax practitioners. Several countries and jurisdictions maintain tax systems based on a flat-tax model. Section 4 presents the flat-tax systems operating in Hong Kong and the Channel Islands.
Hong Kong
Hong Kong has a 16-percent flat-rate tax on corporate profits and a property tax. It does not tax dividends, capital gains, wealth, or gifts. There is also no value-added tax, general sales tax, or payroll tax.
Hong Kong has a Salaries Tax on all employment income. The maximum tax on salaries and wages is a flat rate of 15 percent on gross income, less personal exemptions, expenses, and charitable donations. The Salaries Tax operates according to a sliding scale. The effective rates of income tax are: 10.2 percent for a single person; 5.7 percent for a single person with two dependent parents; 3.5 percent for a married person with no children; 1.4 percent for a married person with two children; and 0.14 percent for a married person with two children and two dependent parents.
In Hong Kong, personal and child allowances are so high (including a maximum deduction of 10 percent of taxable income for charitable donations) that 70 percent of the population pay no income tax at all; a further 28 percent of the population pay at below the 15-percent flat rate. Consequently, the 15-percent flat rate is paid by only the most affluent two percent of Hong Kong residents.
The Channel Islands
The tax systems employed in the Channel Islands of Guernsey and Jersey are quite similar. Both islands employ a 20-percent standard rate of income tax for individuals and corporations. Neither island imposes a capital gains tax, a capital transfer tax, or a withholding tax, and refrain from taxing bank deposit interest. Nor does either Guernsey or Jersey collect a value-added tax.
Although the Channel Islands' 20-percent standard rate of income tax is very low by international standards, the 20 percent flat tax is reduced further by generous personal allowances and reliefs, which include both single and married person's allowances, as well as allowances for children and dependent relatives.
Conclusion
The fairest, most efficient, and simplest tax system upon which to base reform of the Canadian tax system is a flat tax based on the work of Hall-Rabushka. Such a system would provide enormous positive incentives for hard work, savings, and investment. The evidence suggests that the economic benefits of implementing a flat-tax system would include greater rates of economic and income growth, higher levels of capital formation and investment, and greater social welfare.
The flat-tax system would not, as many argue it would, eliminate the principle of progressivity. Rather, a flat-tax system that includes a personal exemption would enable Canada to maintain progressivity while by-passing the costs of high and increasing marginal tax rates.
Viewing such reform over the course of one's life rather than within a single year shows that nearly all taxpayers would gain from such a reform. In short, a flat-tax system of taxation presents enormous economic benefits with very few economic costs. The Hall-Rabushka flat tax should be the model upon which Canada begins to discuss and design real tax reform.
Notes
1. For a discussion of the marginal efficiency of different taxes see Jorgenson and Kun-Young 1991 and Kesselman 1997.
2. If RRSP or RPP contributions were included as eligible deductions from taxable income, then the tax system would approach a nearly pure consumption tax.
3. In a technical sense, the average tax rate increases as individuals earn more while the marginal tax rate remains flat, achieving progressivity without incurring increasing marginal tax rates.
4. The application of a flat tax within the tax cases presented is restricted to personal income due to limitations in the SPSD/M. It does not, therefore, include other major sources of tax revenue such as corporate income.
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