As the debate on Flat taxes in the US gets louder, one thing that is lost in the debate is the very purpose of a tax system which consists of multiple taxes levied on different tax bases.
The principal taxes in the US are the Sales Tax, the Income Tax and the Property Tax. While each of these taxes provide revenue, each of them play a different role. The Sales Tax and the VAT are essentially taxes on consumption and are revenue generating instruments. The Corporate Income Tax like the Sales Tax and VAT serve a primary purpose of generating revenue. The Property Tax is primarily used to pay for local public goods such as schools and the police. The Personal Income Tax on the other hand is an important tool promoting equity apart from its revenue purpose. No other tax is so suited to promote equity. The primary mechanism as to how a Personal Income Tax does this is through progressive tax rates with higher incomes attracting higher tax rates and lower incomes either having a lower tax rate or exempt from tax or some even receiving a payment from the government such as in the case of an Earned Income Tax Credit (EITC). For a detailed discussion of this, see section 4.1 in the chapter on Simplifying Tax Policy in the Handbook of Tax Simplification that I authored http://documents.worldbank.org/curated/en/317341468335679099/A-handbook-for-tax-simplification.
Policy makers sometimes confuse these purposes. Take the example of the VAT or Sales Tax. Some countries levy different rates for different goods with the aim of introducing equity into the tax. The VAT or the retail Sales Tax is a broad based tax on consumption and is an excellent instrument to generate revenue. Trying to introduce equity into this tax only reduces the ability of this tax to work properly creating opportunities for tax leakage and making its administration difficult. For example, goods that are typically consumed by the poor are levied Sales Tax or VAT tax at a lower rate. Basic food items such as rice and bread typically attract a zero rate. While this makes for good optics, such an exemption also benefits the rich who also consume these basic food items and typically in larger quantities. While it is not equitable, exempting it from the tax for the purpose of equity leads to loss of revenue, revenue that could be used to fund the government programs that could be better directed to the poor.
In this regard a flat personal income tax which replaces the progressive tax rates with a single tax rate that applies to all taxpayers strips out the equity aspect of the tax for which it is primarily designed. Most of the supporters justify this in the name of simplification, but the progressivity of a tax system is the least problematic part of the complexity of the tax system.
The US curiously has a progressive corporate income tax. The idea of introducing equity among corporations that are legal entities through higher tax rates for higher corporate profits is without a strong basis. A flat tax among coporations has another dimension. Corporate Income Tax typically has several tax exemptions that encourage certain activities. These make the effective tax rates of different corporations widely different depending on the number of exemptions they are eligible to. Flattening the Corporate Income Tax typically involves removing many of these exemptions to replace the complex system with one that is simple and imples nearly similar effective tax rates for all corporations.
So what can we take out of the the Flat tax debate ? That while trying to come up with a Flat Corporate Income Tax makes sense, doing the same for Personal Income Tax is a bad idea.
(Disclaimer: The views expressed in this blog are personal and should not be attributed to the World Bank Group)
The principal taxes in the US are the Sales Tax, the Income Tax and the Property Tax. While each of these taxes provide revenue, each of them play a different role. The Sales Tax and the VAT are essentially taxes on consumption and are revenue generating instruments. The Corporate Income Tax like the Sales Tax and VAT serve a primary purpose of generating revenue. The Property Tax is primarily used to pay for local public goods such as schools and the police. The Personal Income Tax on the other hand is an important tool promoting equity apart from its revenue purpose. No other tax is so suited to promote equity. The primary mechanism as to how a Personal Income Tax does this is through progressive tax rates with higher incomes attracting higher tax rates and lower incomes either having a lower tax rate or exempt from tax or some even receiving a payment from the government such as in the case of an Earned Income Tax Credit (EITC). For a detailed discussion of this, see section 4.1 in the chapter on Simplifying Tax Policy in the Handbook of Tax Simplification that I authored http://documents.worldbank.org/curated/en/317341468335679099/A-handbook-for-tax-simplification.
Policy makers sometimes confuse these purposes. Take the example of the VAT or Sales Tax. Some countries levy different rates for different goods with the aim of introducing equity into the tax. The VAT or the retail Sales Tax is a broad based tax on consumption and is an excellent instrument to generate revenue. Trying to introduce equity into this tax only reduces the ability of this tax to work properly creating opportunities for tax leakage and making its administration difficult. For example, goods that are typically consumed by the poor are levied Sales Tax or VAT tax at a lower rate. Basic food items such as rice and bread typically attract a zero rate. While this makes for good optics, such an exemption also benefits the rich who also consume these basic food items and typically in larger quantities. While it is not equitable, exempting it from the tax for the purpose of equity leads to loss of revenue, revenue that could be used to fund the government programs that could be better directed to the poor.
In this regard a flat personal income tax which replaces the progressive tax rates with a single tax rate that applies to all taxpayers strips out the equity aspect of the tax for which it is primarily designed. Most of the supporters justify this in the name of simplification, but the progressivity of a tax system is the least problematic part of the complexity of the tax system.
The US curiously has a progressive corporate income tax. The idea of introducing equity among corporations that are legal entities through higher tax rates for higher corporate profits is without a strong basis. A flat tax among coporations has another dimension. Corporate Income Tax typically has several tax exemptions that encourage certain activities. These make the effective tax rates of different corporations widely different depending on the number of exemptions they are eligible to. Flattening the Corporate Income Tax typically involves removing many of these exemptions to replace the complex system with one that is simple and imples nearly similar effective tax rates for all corporations.
So what can we take out of the the Flat tax debate ? That while trying to come up with a Flat Corporate Income Tax makes sense, doing the same for Personal Income Tax is a bad idea.
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