Flat Tax
Principles and Issues

1 Average taxes, marginal taxes and progressivity

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Section 1 of the study explains differences between average and marginal tax rates, shows how progressivity can be achieved with a flat tax (the analysis is equally applicable to a single-rate tax systems), and describes the negative effects of high and increasing marginal tax rates.

Marginal and average taxes

The terms "marginal tax rate" and "average tax rate" are often confused in discussions of tax policy. The average tax rate for an individual, family, or business is simply the total amount of taxes paid relative to the total amount of income earned. For instance, the average tax rate for an individual who earned $40,000 and paid $10,000 in taxes would be 25%.

Marginal tax rates, as the name indicates, apply at the margin. That is, marginal tax rates are relevant on an incremental basis. In other words, the marginal tax rate is the rate that applies to the next dollar of income earned. For example, if an individual who earned $40,000 received a raise of $5,000, raising her income to $45,000, the tax rate applicable to the last dollar of the raise of $5,000 would be the marginal tax rate. If $2,000 of the $5,000 raise were taxed away, the marginal tax rate would be 40%.

Illustrated example

Let us assume, for illustrative purposes, that only the four 2000 federal statutory rates (0%, 17%, 25%, and 29%)¹ of income tax exist, that the personal exemption ($7,231) also exists and that no deductions from income are permitted. Table 1 summarizes the 2000 income brackets within which each rate applies.

Let us further assume that an individual currently earns $30,004. The individual would pay $3,871 in federal income tax given his income.² This represents an average tax rate of 12.9%. Recall that average taxes are simply the ratio of taxes paid ($3,871) to total income ($30,004).

Let us now assume that the individual receives a raise of $1,000. His income would, therefore, increase to $31,004. We are interested in the marginal rate of taxation faced by the individual given his raise. Recall that marginal taxes are applied at the margin, that is, on additional income.

The additional income gained from the raise will place the individual in a higher tax bracket. He will now face a tax rate of 25% on the income above $30,004. In other words, his current marginal tax rate is 25%; his marginal tax rate will remain at 25% until his income exceeds $60,009, when the next tax rate will apply. This individual will, therefore, pay $250 in federal income tax on his raise rather than $170, which he would have been assessed using the lower tax rate. The individual has, therefore incurred an additional tax liability of $80 due to the higher rate of taxation.

The individual's average tax rate would also change. The individual's total tax bill for the year would now be $4,121, an average federal tax rate of 13.3%.

It is important to distinguish these two concepts of taxation. Average tax rates, on the one hand, represent the total tax burden on individuals, families, and businesses relative to their total income. Marginal tax rates, on the other hand, indicate the rate of income tax paid on marginal or incremental income.

Influence of high and increasing marginal tax rates

When deciding whether to work an additional hour, to increase one's human capital through education, or to invest one's savings, the tax rate most important to an individual or business is the marginal tax rate. It matters most because it directly affects the proportion of increased income that can be kept. The higher the marginal tax rate, the lower the return to productive activity and, thus, the lower the level of incentives for the individual, family, or business.

The folly of demanding higher and higher marginal tax rates for those in the upper income brackets is that this effectively provides disincentives for the most productive members of society to be productive. In so much as this reduces economic growth that benefits all members of society, increases in tax rates can eventually result in each of us being worse off than we might otherwise have been, even if our own marginal tax rate is much lower than that of the wealthiest individuals.

Table 1: Federal statutory rates (2000)

Source: The Budget Plan 2000, Department of Finance, 2000.
Note: * Rate reduction to 23% will be fully implemented by 2001.

Marginal tax rates and maximizing social welfare

A particularly interesting study of the connection between social welfare and marginal tax rates is found in Gruber and Saez (2000). In this paper, the authors derive optimal tax rates based on different assumptions of how the government values³ the incomes of citizens in different tax brackets and the responsiveness of individuals in these different brackets to increases in their marginal tax rate. The task for the government is to raise the revenue necessary for its functioning (provision of goods and services, income redistribution, and debt servicing) while maximizing social welfare, given how individual behaviour will change as tax rates are modified.

Gruber and Saez present a number of different situations, including an example where the government values revenue from each income bracket equally, one where the government does not value the income of the top bracket at all (labelled "progressive"), and one where almost everyone is treated equally, except for the very poor, whose welfare the government is more concerned about. Their finding is that for each of these cases the optimal structure of marginal tax rates should be declining as you move up from lower to higher income brackets rather than increasing. In other words, the marginal rates of taxation should be decreasing not increasing as one's income increases.

This result holds even in the case where the government is "progressive." ⁴ Given the behavioural responses of individuals, the authors conclude that in order to maximize social welfare "the optimal tax system should feature declining (or at least not increasing) marginal rates, although perhaps increasing average rates" (Gruber and Saez 2000: 34).

High marginal tax rates and
formation of capital

Most commentators would agree that investment is important for the future well-being of a nation. High marginal tax rates lower the returns to investment and the incentives for the entrepreneur. Carroll, Holtz-Eakin, Rider, and Rosen (1998) find that "a 5 percentage point rise in marginal tax rates would reduce the proportion of entrepreneurs who make new capital investment by 10.4%. Further, such a tax increase would lower mean capital outlays by 9.9%" (1998: 2).

In a recent paper, Gustavo Ventura (1999) modelled the effects of a broad-based flat tax reform initiative such as that proposed by Hall and Rabushka (see Section 2). Ventura concluded that the elimination of taxes on capital did indeed have a positive effect on capital accumulation. He also concluded that aggregate labour supply, measured in efficiency units, would also increase.

High marginal tax rates and economic growth

In a statistical sense, both average and marginal tax rates can influence economic well-being. A larger size of government and larger corresponding average tax burden(s) can translate into lower economic performance, especially as an expanding government tends to get involved in activities not consistent with furthering economic growth (Gwartney, Halcombe, and Lawson 1998). Marginal tax rates, however, can have a separate influence on the incentives facing the factors of production and, thus, ultimately on economic well-being. Several papers have tried to disentangle these two effects.

For example, Koester and Kormendi (1989) find that after controlling for average tax rates, increases in marginal tax rates have negative effects on the level of economic activity. In other words, reducing the "progressivity" of the tax system while allowing the government the same tax revenue as a percent of GDP leads to higher levels of national income. Since the tax base increases while the average tax rate remains unchanged, this suggests that governments can actually increase their revenues by moving to "flatter" tax systems.

Mullen and Williams (1996) derive marginal tax rates for the American states using a method similar to that of Koester and Kormendi (1989). Their model controls for initial income, the growth rate of the capital stock, and the growth in the labour force. After looking at a number of different estimates they conclude that "lowering marginal tax rates can have a considerable positive impact on growth . . . creating a less confiscatory tax structure, while maintaining the same average level of taxation, enabling sub-national governments to spur economic growth" (Mullen and Williams 1996: 703).

Becsi (1996) uses a method similar to that of Koester and Kormendi (1989) to derive marginal tax rates for the American states. He finds that differences in marginal tax rates across states have a statistically significant effect on relative growth rates. For the time period examined, Becsi finds that "state and local taxes have temporary growth effects that are stronger over shorter intervals and a permanent growth effect that does not die out over time" (Becsi 1996: 34).

Finally, Engen and Skinner (1996) examine a number of studies looking at evidence from the United States and abroad. They conclude that "a major tax reform reducing all marginal rates by 5 percentage points, and average tax rates by 2.5 percentage points, is predicted to increase long term growth rates by between 0.2 and 0.3 percentage points" (Engen and Skinner 1996: 34). While this may appear small, the cumulative effective can be enormous. They speculate that if an inefficient tax structure had been in place in the United States from 1960 to 1996, the amount of output currently lost would have totalled more than $500 billion annually or 6.4% of 1996 GDP.

Progressivity

The evidence is already quite strong and still growing that high and increasing marginal taxes have negative economic consequences. One of the main benefits of a flat tax is that it is able to achieve progressivity in the tax system--those earning more, pay more in taxes--while at the same time eliminating the damaging effects of high and increasing marginal tax rates.

One of the most fundamentally misunderstood aspects of the flat tax and, for that matter, of the single-rate tax is their effect upon progressivity and marginal taxation. Progressivity refers to the amount of taxation contributed by each income group. The traditional concept of progressivity, often referred to as vertical equity, has been that individuals earning more should contribute more in taxes in an absolute sense. That is, as individuals and families earn more, they should pay proportionately more in taxes.

Progressivity has traditionally been achieved by progressively higher statutory tax rates. Figure 1 illustrates the progressivity present in the 2000 basic federal tax system. There are four statutory rates: 0%, 17%, 25%, and 29%. Income earned below the level of $7,231 is exempt from federal taxation. Income earned between $7,231 and $30,005 is taxed at a rate of 17%. Income earned above $30,004 but below $60,010 is taxed at the higher rate of 25% and finally, income earned above $60,009 is taxed at 29% (see table 1 for a summary of this information).

In addition to the four federal statutory rates, there is a federal surcharge, federal payroll taxes, provincial taxes (including surcharges), and provincial and federal tax credits to consider. For simplicity, only the federal statutory rates are presented to illustrate the concepts of progressivity and marginal taxes.

Progressivity is currently achieved through progressively higher statutory tax rates. However, increasing marginal tax rates also introduce the negative effects discussed previously. Specifically, achieving progressivity through high and increasing marginal tax rates creates disincentives for entrepreneurial activities, innovation, savings, and investment.

The flat tax can eliminate the negative effects of high and increasing marginal tax rates while maintaining progressivity. Individuals, families, and businesses continue to contribute an increasing amount of their income as they earn more but no longer face increasing marginal tax rates. Progressivity within a system based on a flat tax or a single-rate tax is achieved through an exemption. Thus, progressivity is achieved while at the same time avoiding the disincentives associated with high and increasing marginal tax rates.

Illustrated example

Progressivity is introduced in a flat-tax system through a personal exemption. A personal exemption allows individuals, families, or businesses to earn a certain level of income before they are assessed income taxes. Figures 2 and 3 and table 2 illustrate the effect the introduction of a personal exemption has on both the proportion of income paid in taxes and the average rate of taxation. The marginal rate of taxation beyond the personal exemption remains constant at 20% and 30%, respectively. The first dollar, and every subsequent dollar earned beyond the personal exemption is taxed at the same uniform rate. Thus, there is only one point at which the marginal tax rate changes based on the federal statutory tax rates: moving from the exempted income with zero taxation to the non-exempt income with some positive rate of taxation.

Table 2: Two scenarios of the flat tax

Notes: Scenario 1--$10,000 exemption with a 20% single tax rate. Scenario 2--$20,000 exemption with a 30% single tax rate. Data and calculations are for illustrative purposes only and do not represent modelled tax calculations.

Figures 2 and 3 also show that the proportion of income paid (average or effective tax rate) in tax increases as one's income increases. As the level of personal income increases, the amount of income or average rate of taxation approaches the actual flat rate of taxation although it never actually equals the flat rate due to the presence of the exemption.

This, in fact, is one of the trade-offs that must be considered when developing a flat tax. The larger the exemption, the larger the rate of tax that must be applied to all income above the exemption in order to achieve sufficient revenue. The larger the exemption and, thus, the higher the rate of the flat tax, the larger the marginal disincentive effect present at the point of taxation. That is, the strength of the disincentive present at the point at which individuals begin to pay taxes will increase as the exemption and tax rate increase. A crucial step in the development of a tax system based on a flat tax is the determination of the exemption level and its corresponding tax rate. Section 3 presents nine cases to illustrate this and other trade-offs.

Conclusion

It is important to note when reading this study and other analyses of tax reform the basic differences between average and marginal tax rates when assessing tax policy. Further, it is vital to acknowledge the growing body of research confirming the rather large negative effects associated with high and increasing marginal tax rates. Finally, one should acknowledge that progressivity can be achieved through a flat tax or a single-rate tax without incurring the costs associated with the negative incentives arising from high and increasing marginal tax rates.

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