Flat Tax
Principles and Issues
Introduction
During a period of balanced budgets accompanied by solid, if unspectacular, economic growth, public attention is increasingly turning again to a critical element of macroeconomic policy, namely taxation. A growing number of analysts and commentators currently advocate reforming the Canadian tax system. Agreement, however, ceases at this point as there are a myriad of specific proposals for tweaking, refining, even significantly altering our current mechanisms for collecting taxes.
This study offers a reassessment of the appropriate role of taxation in the contemporary Canadian economic environment. Consequently, our analysis is more definitive, comprehensive, and, most importantly, empirically rigorous than other fiscal remedies circulating throughout the Canadian body politic.
The authors of this study contend that the goal of tax policy should be to finance the desired level of government spending in the least distortionary manner. Unfortunately, governments of all political persuasions throughout Western nations have, over the course of the last half-century, implemented interventionist tax policies aimed at influencing the behaviour of individuals, families, and businesses. These tax policies distort the economy.
Distortion is created by the tax system through the use of exemptions, deductions, and tax credits, which effectively increase the costs of certain types of behaviour and decrease the costs of other types of behaviour. These tax-based distortions reduce economic efficiency and complicate the tax system beyond what is necessary.
In Flat Tax: Principles and Issues, we aim to clarify many of the issues and principles related to tax reform based on a flat tax as presented in section 2 and modelled in section 3. The study will examine a number of issues related to these types of tax reform, such as progressivity, marginal and average tax rates, income mobility, and international experience with the flat tax. In addition, a number of possible implementations of the flat tax are presented and analyzed.
This study should be viewed as a first step in the development of a comprehensive plan for the implementation of a broad-based, integrated flat tax on personal and business income. It discusses the principles and establishes a solid foundation upon which to build future research into the viability of implementing a flat tax.
Flat tax versus single-rate tax
There is a major difference between a reform of the tax system that would introduce a broad-based, integrated flat tax and the replacement of multiple rates of taxation with a single tax rate, as planned by the Province of Alberta for 2001 and as proposed by the federal Canadian Alliance Party.
Tax reform based on a flat tax involves broad-based change wherein all types of income, both personal and business are uniformly taxed once at one rate. In other words, every source of income is taxed once and at the same rate. The introduction of a flat tax also encompasses the elimination of all or most tax credits, deductions, and exemptions.
Tax reform based on a single-rate tax, on the other hand, simply involves replacing multiple rates of taxation with a single rate of tax. The reforms proposed by the Canadian Alliance affect only personal income and therefore retain differential rates of taxation on different types of income. They also retain all of the tax credits, exemptions, and deductions contained in the current system. The single-rate tax base is, therefore, less broad than a flat-tax base.
Outline of the study
The study contains five main sections that are complementary although not dependent upon one another. That is, each section can be read and understood independently of the other sections. Section 1 describes the basic differences between average and marginal rates of tax, explains the principle of progressivity and how it can be achieved with a flat tax or a single-rate tax, and summarizes the economic research on the negative effects of high and increasing marginal tax rates. It clarifies many of the issues that inevitably arise when discussing tax reform in general and particularly tax reform based on either a flat tax or single-rate tax.
Section 2 summarizes one of the earliest and most prominent American proposals of a flat tax. Professors Robert E. Hall and Alvin Rabushka of the Hoover Institution were two of the earliest scholars formally to present plans for broad-based tax reform founded on the principles of a flat tax. Although the analysis studies tax reform in the United States, the principles that underlie the proposal are equally applicable to Canada.
Section 3 presents the results of a taxation model created by the authors based on Statistics Canada's Social Policy Simulation Database and Model (SPSD/M); it is highly quantitative in nature. The section presents nine possible cases ranging from a basic flat tax with no exemptions or tax credits to a flat tax with a personal exemption, an exemption of $2,000 per child, a deduction for RRSP/RPP contributions, and a deduction for charitable donations.
Two cases are also presented that combine a flat tax with reductions in taxes and expenditures implemented at the federal level. The section is meant to present possible options for the implementation of a flat tax and to illustrate the trade-offs, tax rates, and distribution of taxation given the particulars of each case.
It should be noted that Section 3 only investigates the effect of tax changes on personal income. Due to the design of the SPSD/M and related technical complexities, the flat-tax cases presented in this section, like the single-rate tax enacted in Alberta and proposed by the Canadian Alliance, do not include reform of business taxes. Nonetheless, the cases in this section provide an important step forward in the discussion of the possibilities available for tax reform and the various trade-offs present in the reform process.
Section 4 places the issue of tax reform based on a flat tax in the context of a lifetime tax liability analysis. That is, it explains why and how we should think about tax liabilities in terms of an individual's life rather than in the context of a particular year. The section demonstrates how specific tax reforms are affected by age and the lifetime pattern of earnings. The section further highlights the highly transitory nature of income and the flaws present in much of the tax analysis that are based on single-year analyses.
Finally, Section 5 discusses the flat tax as presently used by Hong Kong and the Channel Islands. The section is presented to establish that the flat tax is a viable possibility that is already in use and not some theoretical construct that has yet to be concretely tested.
It is our hope that this study will establish a foundation for a rational discussion of tax reform based on a flat tax as well as creating a platform from which to undertake further research.
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