Flat tax systems are often discusses these days. The aim of flat tax systems is to simplify and substitute current tax systems, which nobody fully understands. Even tax professionals, who should understand taxation, do not know everything about taxes. (If you ever meet a guy who claims to know everything about taxes, you should slowly move towards the door, maintain eye-contact and never ever turn your back towards that person. You don’t want to show your back to someone who knows everything about taxes.) Corporate taxation, taxation of individuals, direct and indirect taxation, inheritance tax, sales tax, interest, capital gains, property tax… and there are many many more. Yes, tax systems are complex.
The aim of a flat tax system is to simplify such tax codes so that everyone can understand it. However, it is difficult to realize such system and here is why:
Flat tax system 101
Let’s say there is country A, which implements a very simple flat tax system. The only tax that is levied in this country is a tax on consumption. Think of something like a sales tax or VAT. Every time you purchase something you pay 90% tax. The number is arbitrary, but considering that all other taxes are dropped, that tax rate must be quite high. Let’s assume that such a tax rate is enough to secure the tax revenue that keeps country A running. This is very simple but what are the consequences?
Consequences of a consumption based flat tax system
If consumption is taxed, people who consume less pay less tax than people who consume more. That seems unfair. However, it is your choice whether to consume or not. But you must consume in order to live. So high consumption households (big families for example) face a higher tax burden than singles. In other words, frugal people benefit more than individuals with lavish spending habits. If people realize that frugality is rewarded they will try to minimize consumption and country As’ citizens will become famous for being frugal. They start producing their own vegetables in their backyard, in order to avoid taxation. Maybe they engage in barter and swap chickens for cucumbers, coffee for milk and so on. But this would only happen in a single country environment (Besides the fact that this is a clear backward development of an economy nobody wants). But we’re not living in such a single country world. We have neighboring countries and borders, which we are allowed to cross. What would you do in such a situation?
People will try to shift consumption to other places where it is taxed less. You realize that country B taxes consumption at a lower rate. Therefore, you start buying your groceries in country B, while earning your income in country A. Maybe you decide to move near the border, because that makes life easier and more profitable. On the other hand, people from country B realize that income in country A is not taxed. So they try to generate income in country A. Maybe they are not willing to move, but they start investing in country A because the capital gain is not taxed over there.
You see that such dramatic change in a tax systems shifts the incentive of the citizens and that can have a severe economic impact.
Flat tax on income
Let’s consider a slightly more complex flat tax system, where all income is taxed at a flat tax rate of 25%, no matter how much you earn. Country B does not introduce such flat tax and decides to tax its’ citizens with normal progression. The citizens of country A, who earn less than €Xk (this is the amount where the two lines cross each other) are in a less advantageous situation, since their income is taxed at a higher rate than before (the grey shaded are). On the other hand, taxpayers who earn more than €Xk benefit from this tax system since their income is taxed lower than before (the red shaded area). This would mean that low income earners have now an incentive to move out of country A, while high income earners prefer to become a citizen of country A.
Country B will definitely not like such move of country A and starts to think about doing something nasty to country A. This represents basic tax competition between two jurisdictions. A change in a countries’ tax system affects other foreign economies and that leads to a conflict between the jurisdictions. Country A doesn’t want that, so they cannot change the tax law dramatically.
Therefore, a flat tax might be a very promising idea to simplify national tax systems, but if you take a look at the consequences you see that there is much more to take into account than a simple tax rate. Today, taxation is not only a national matter anymore. A flat tax changes the rules of the game and this can only be done successfully if all players agree. Similar to bar-hopping with 20 people: Finding the location where everyone is happy is not an easy task.
What was your first impression when you heard something about “flat tax” systems? Did you like it? If such a system leads to tax competition, why not? Do you think countries should compete over tax revenue?
When I first heard about flat tax systems, i said: AWSUM!
Besides your (very valid, as always) arguments, a flat tax system seems VERY liberal, even libertarian. That is basically the reason why it will probably never be introduced in any European state. It’s too libertarian: only pay for yourself, if you are better, well, the others are screwed. Tax breaks, different tax classes and all that are a social net that is tightly interwoven with all kinds of decisions and processes. We will never get it out of Europe (, thankfully).
Imagine what would happen in a shift: ALL tax lawyers and consultants will lose their jobs (except for international tax people like Ken), EVERYBODY would basically have to renegotiate their salaries, complete Government Agencies would cease to exist, etc. That is why such shifts happen only after a country is founded, invaded, or destroyed. Schumpeter is your friend here.
Maybe Greece could use a shift?
Hey Philipp, thanks for your comment! I thought the same: “Boom… there it is: iTaxFlat! This is our new product.” Actually, there are a couple of countries that have a flat tax system in place. They are mainly smaller eastern European countries. Corporate tax rates become more and more “flat”. The example in the post was maybe too simple, but I did not intend to say that a flat tax system is not possible at all. There are double tax treaties and stuff you can use to make it a success. But nevertheless, it is a big big change in tax policy and it certainly does influence international relations between countries.
In transfer pricing, there is the idea of an “one-stop-shop” taxation system for corporations. It’s called the Common Consolidated Corporate Tax Base (CCCTB). I’ll cover that in upcoming posts. But the CCCTB can be regarded as some dramatic change in transfer pricing business. You mentioned an interesting fact: people will lose their jobs. That is a fear that stops us from initiating change. Since emotions are involved, you never know how people will react and it’s also not an issue anymore of simply stating the facts why the A tax system is better than B.
I like taxation because it involves a lot of factors. The obvious ones are economics, law and politics. But there are more subtle areas, which tax people should have some knowledge about: cognitive psychology, behavioral economics, negotiation (yes, you can negotiate your taxes), personal finance (e.g. small business owners often have problems with tax debt) and even game theory (the example in the post above could be explained in a game tree)… and there are many more things your tax guy should know. Why? because taxation is not an scientific island. If there is action, there is also a reaction and you want to make sure that your tax guy is able to recognize the links between these. Otherwise the service of a tax professional will be replaced by intelligent computer technologies in the near future.