July 2001
Many Good Reasons for a Flat Tax
by Jason Clemens & Joel Emes
Tax reduction has almost completely overshadowed the equally important issue of tax reform. Even when some attention was paid to this important issue, such as in the 2000 federal election campaign, much, if not all of the discussion, was riddled with misinformation that prevented an open and frank debate about tax reform.
As the following article demonstrates, there are both inherent and competitive reasons for tax reform based on a flat tax.
Inherent advantages of a flat tax
The traditional evaluation criteria for effective taxation are efficiency, fairness, and simplicity. Comparing today's tax system with a flat tax according to these three criteria results in an overwhelming case for the introduction of reforms based on a flat tax.
(1) Efficiency
Efficiency requires that economic distortions be minimized when taxes are imposed. Our current tax system distorts economic decisions in a variety of ways, mostly by making some activities less expensive through tax incentives, and other decisions more expensive through punitive taxation. A flat tax, on the other hand, removes nearly all of these tax-based programs, thus minimizing the amount of economic distortions caused by these special-interest driven initiatives.
(2) Fairness
Fairness, or what is now referred to as equity, has two components: horizontal and vertical.
Horizontal equity
Horizontal equity requires that individuals or households with similar incomes face similar tax burdens. This means that different types of income must be treated equally–which they are not in today's system. Certain types of income, such as some work-related benefits, face no taxation while other types of income, particularly business-related income, face multiple layers of taxation. Further, there are biases in the tax code towards two-income families and against one-income families.
One of the main strengths of a flat tax is that is treats all sources of income equally. Specifically, a flat tax fully integrates personal and business income to ensure that all sources of income are taxed once and at a uniform rate. In other words, regardless of where households receive their income, they will face similar income taxes when their incomes are proximate.
Vertical equity
The second component of fairness is vertical equity, which requires that individuals pay more tax as their incomes increase. Unfortunately for Canadians, this is achieved through progressively higher marginal tax rates. There is ample evidence that high and increasing marginal tax rates contribute to lower rates of economic growth, reduced rates of capital formation, lower than expected aggregate labour supply, and reduced social welfare (Emes and Clemens). In short, high and increasing marginal tax rates reduce economic growth by creating disincentives to hard work, savings, and investment. So although the current system achieves vertical equity, it does so at an extremely high cost to the economy.
Another major advantage of a flat tax is the manner in which it achieves vertical equity. By including a personal (and spousal) exemption, a flat tax ensures that as individuals and households earn more, they also pay more in taxes. In fact, the percentage of income paid in taxes increases as the earnings of the household increase, thus achieving progressivity. However, by eliminating high and increasing marginal tax rates, a flat tax avoids many, if not all of the costs associated with them, namely, lower economic growth and reduced savings and investment. Put differently, a flat tax can achieve vertical equity while at the same time maintaining incentives for hard work, savings, investment, risk-taking, and innovation —all of which Canada needs more of.
(3) Simplicity
The final criterion, simplicity, refers to the levels of citizens' comprehension of the tax system, and their ease of complying with it. Most people do not readily understand the current system. The various tax forms and regulations associated with them have spurred an entire industry of tax accountants, lawyers, and planners. Simplifying the system is a central part of flat tax reform.
What a flat tax would look like
There is both an opportunity and a need for fundamental reform of the Canadian tax system based on efficiency, fairness, and simplicity. The question becomes, what does fundamental tax reform look like? Our recent study, Flat Tax: Principles and Issues explains why tax reform should be based on a flat tax. In particular, we recommended a system based on the work of professors Robert E. Hall and Alvin Rabushka of the Hoover Institution. Their proposal (hereafter referred to as Hall-Rabushka) fully integrates the personal and business income tax systems. It is, therefore, able to tax all types of income once and at one tax rate.
The Hall-Rabushka model contains no tax credits, deductions, or exemptions, except for the personal, spousal, and child exemptions. The myriad tax breaks present in the current system are eliminated, as are the accompanying complicated and time-consuming paperwork. The model simplifies the determination of income which constitutes much of the complexity associated with the current tax system.
Our analysis of a flat tax on personal income based on the Hall-Rabushka model indicates that Canada could have a flat tax of 18.3 percent at the federal level with $8,766 personal and spousal exemptions along with a $2,000 per child exemption. A married couple with two children would not pay federal income tax until their income exceeded $21,532.
Taxing consumption
Another benefit of the Hall-Rabushka model is that it effectively moves the income tax system away from one based on income towards one based on consumption. A consumption tax is levied on any income that is consumed—spent rather than saved. Hall-Rabushka excludes savings—investment—from taxation. Taxing consumption creates minimum distortions since it only exempts savings; all expenditure, regardless of its nature, is taxed. Taxing consumption rather than income increases the efficiency of the tax system.
Competitive advantages of a flat tax
In addition to the reasons listed above, there are also relative or competitive reasons for adopting tax reform based on a flat tax. Canada is currently searching for ways to be more competitive with the US. When it reduced taxes last year, the federal government stated that one of its reasons in doing so was to make our rates more competitive with those in the US.
Apparently the government ignored the possibility of completely overhauling our tax system—that is, the way in which we collect taxes—to create a competitive advantage with the United States. Currently, there are some 740 different tax forms in the US with 250 or so publications explaining the forms. The US Tax Foundation estimates that Americans spend about 4.3 billion hours a year filling tax forms at a cost to the economy of $125 billion. The recent Senate approval of the Bush tax plan (slightly amended) will only worsen the complexity of the tax system (du Pont, 2001).
In fact, amendments made by the Senate to the Bush tax proposal will actually steepen the marginal nature of personal income tax rates in the US. Instead of flattening the personal income tax rates, the Senate amendments create an additional tax bracket, increasing the total number of brackets from 5 to 6: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent (Deloitte & Touche). This change will likely worsen the negative economic effects of increasing marginal tax rates.
The complexity of the US tax system provides Canada with a unique opportunity to establish a real economic advantage over our neighbours. By reforming our tax system, specifically by implementing a flat tax based on the Hall-Rabushka model, Canada could greatly simplify its tax system and achieve the three traditional criteria for effective tax policy, and in doing so, establish an administrative advantage over the US tax system. If Canada were to actually combine significant tax reductions with the tax reform suggested we may even achieve an economic advantage.
Conclusion
The fairest, most efficient, and simplest tax system upon which to base reform of the Canadian tax system is a flat tax. 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 main roadblock to a flat tax system, or even a reasonable discussion of one, is the misinformation presented by flat tax opponents.
References
Aaron, H., and J. Pechman (eds) (1981). How Taxes Affect Economic Behaviour. Washington, DC: Brookings Institution.
Altig, David, and Charles T. Carlstrom (1994). "The Efficiency and Welfare Effects of Tax Reform: Are Fewer Brackets Better Than More?" Economic Review 30, 4: 30-42. Federal Reserve Bank of Cleveland.
Davies, James (1998). Marginal Tax Rates in Canada: High and Getting Higher. C.D. Howe Institute Commentary 103 (March).
Du Pont, Pete (2001). "A Complicated Cut." Wall Street Journal. May 30. Digital document: http://interactive.wsj.com/fr/ emailthis/retrieve.cgi?id=SB991200734322375258.djm.
Emes, Joel, and Jason Clemens (2001). Flat Tax: Principles and Issues. Critical Issues Bulletin. Vancouver, BC: The Fraser Institute. Available at www.fraserins- titute.ca/publications/critical_issues/ 2001/flat_tax/index.html.
Garay, Mark (2001). Seeds of Change. Deloitte & Touche. Digital document available at http://www.dttus.com/ PUB/taxcut/default.html.
Hall, Robert E., and Alvin Rabushka (1995). The Flat Tax. Third Edition. Stanford, CA: Hoover Institution Press.
[Flat Tax: Principles and Issues by Joel Emes and Jason Clemens is available from The Fraser Institute for $16.00 (which includes shipping, handling, and GST). Call 1-800-665-3558, ext. 580 to order your copy. The publication is also available on our web site at www.fraserinstitute.ca/publications/critical_issues/2001/flat_tax/ index.html.]
Joel Emes (joele@fraserinstitute.ca) is Senior Research Economist at The Fraser Institute. He has an M.A. in Economics from Simon Fraser University.
Jason Clemens (jasonc@fraserinstitute.ca) is the Director of Fiscal Studies
at The Fraser Institute. He has a Masters Degree in Business Administration
from the University of Windsor.
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