Every now and then, you can find someone advocating flat tax. It is a tax that is already being applied in a few countries today. It is also a tax under consideration of a few others, while there are some that are done with it! In spite of its advocacy, it may not be the best option for any Government.
No tax agency in the world faces such public criticism as the IRS does in the US. Interestingly, much of this criticism is also associated with the demand of flat tax, the kind of which has been experimented in some of the erstwhile Soviet countries. The advocates of flat tax claim it to be a panacea of all ills, while it critics are never impressed. What is this tax and what it brings to our table ?
Most of public support for new ideas like flat tax comes from people who, for some inexplicable reason, presume that it will automatically improve things for them. So you can have a low income guy arguing in favor of something like flat tax or sales tax, without even remotely understanding that he will have to shell out something further from his pocket without getting anything in return. Such is the level of our public ignorance about taxes, shared by all communities across the globe, and usually including even the most educated ones - academicians, scientists, policy makers, and amazingly, even economists, that most make their arguments presuming that anything new will always be beneficial.
Economists traditionally refer to five characteristics of an ideal tax.
It should be fair, simple, neutral, efficient and capable of generating sufficient revenues. The first two of these characteristics are most of the time mutually contradictory. If you keep things simple, e.g.. have a single rate of tax for everyone, then you end up imposing tax at a similar rate on everyone, and that is not fair. The concept of fairness and equity demands that taxes should be levied depending upon the ability of the individuals to pay. But to achieve that, you have to necessarily make things a little more complicated.
Many people argue that a flat tax with an exemption level solves the problem. Unfortunately, that is a mere rhetoric. An exemption level means that there are two rates of taxation - a 'zero' rate and another positive rate, and so this is not the simple flat tax as it is called. It is just a two rates income tax, nothing more, nothing less. The question that needs to be asked is as to how this two rates structure, better than a three rates structure, or a four rates structure.
Multiple rates (including zero rate) are introduced to have a lower rate of taxation for those who can pay less and a higher rate on those who can pay more. This brings about a certain degree of redistribution of income between the rich and the poor, and keeps the balance and harmony in the society intact. It is important to note that social harmony is a very important public good, which needs to be there for the markets to operate freely, and which cannot be purchased easily.
Another argument often brought in favor of flat tax is that it will not be associated with any exemptions, deductions etc. The presumption is that the tax will be very simple, so nobody will have a problem in understanding or paying and evasion will be difficult. Unfortunately, this presumption is irrational. Tax rates have very little to do with the complexities of an 'income tax', which primarily arise from the difficulty in defining what is 'income'. Unlike sales or purchases, which are unambiguous amounts, income is something that is not apparent straight away, and needs to be computed after a detailed accounting. Irrespective of whether there is one rate of tax or five, the complications in the tax system that are associated with the difficulties in calculating income will continue to remain.
Similarly, whether the deductions are to be given or not, and whether there should be incentives or not for altering economic behavior, is a matter that has nothing to do with the tax rate structure. They can always be there, even with a flat tax, and in all probability, will come back again, sooner or later, because of many reasons, including political and others.
So it should be clear that a flat tax is unlikely to bring the dream remedies that it is claimed to bring along. What makes it much less desirable are the adversities that it can cause. First, if you impose a flat tax rate without letting your tax collections fall, then the only way is to do it with a very small exemption limit and with a reasonably high rate of taxation. The taxpayer structure in all communities is pyramidal in shape - there are most people at the bottom, and least at the top of the income ranges. By imposing a flat rate of tax, only a small number of taxpayers at the top of the curve will benefit, while the large majority of taxpayers at the bottom will be made to bear a higher tax burden - not exactly a situation that the proponents of flat tax conceive.
Thus flat tax idea is like a big hot air balloon that appears big and attractive, and flies a lot, but in essence has little substance. The changes it can bring cannot be positive for the social welfare, and the dangers that it encompasses are immense. It will be seen and talked about for a while, and slowly the gas will go out, and the balloon will disappear.
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