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Tax is one of the most common means that governments use to generate funds for public projects. The tax system is a central aspect of the political and economic institutions that influence the long run and day-to-day performance of the country. The tax system represents the formulation of how tax is levied on different sectors of the economy, and the varying aspects of the economy such as personal income, investments, and property. A tax system is the formulation of the rates of tax charged on different factors and sectors in the economy. It also shows how the rate changes with variations in these aspects. The tax system determines the fiscal effects of levying the tax on macroeconomic variables (Albi and Martinez-Vazquez 8).

The Flat Rate Tax System

A flat rate tax system charges an equal proportion of tax on the income of citizens in spite of their income levels. This differs from progressive tax rate systems that charge a higher percentage of tax on people with high incomes than those with lower incomes. One of the most well known economists to popularize the flat tax system was Milton Friedman, who was a prominent advocate of libertarian ideas. He wrote scholarly works on stabilization of the economy, consumption analysis, and monetary theory. Friedman proposed the first flat rate tax on income in 1962. In his opinion, redistribution of income through progressive tax was unfair. It was coercive and conflicted with personal freedom, according to his calculations; a flat rate tax of 23.5% would yield the same amount of revenue for the government as the progressive tax rates that were applied at the time. The estimates used by Friedman also showed that the flat tax rate would result in higher revenue than the graduated tax system. It would also eliminate distortions that influence tax collection and growth in the economy. Removal of tax exemptions, credits, other tax preferences would result in broadening of the tax base (Thorndike).

Many policy makers did not endorse the ideas proposed by Friedman at the time, but the flat tax revolution that started taking place in Europe in the 1980s was based on the ideas presented by Friedman. The flat rate income tax system has gained much attention as a system that can enable the government raise revenue in a manner that has less destructive effects on the economy than the progressive tax system. The principle is applied to charge one low rate of tax for the entire economy. It has also gained popularity as a means of eliminating double taxation on investments and savings. It also removes distortions, corruption, and complexity created by tax exemptions and other tax preferences (Mitchell).

Dick Armey proposed the flat rate tax system in early 1990s, but it was never endorsed by congress. However, the flat rate tax system has been adopted in many countries since 1994. The main reason for the lack of endorsement of flat tax rate in the US was the lack of countries that would serve as examples in their implementation. Hong Kong was the only country that had a flat rate tax system. However, congress believed that it was a special case that would not be replicated in other countries. In 2007, there were 17 countries with flat rate tax systems, most of which are members of the Soviet Union (Mitchell). The likely reason for the acceptance of flat tax in these countries is their communism history, which reduces their vulnerability to rhetoric on class warfare in relation to taxing the rich in society.

The flat rate tax system has achieved attention in recent times and has been motivated by the understanding of the aspects of a good tax policy, and desire for reforms that are supportive of growth. Tax competition is also an important factor in the adoption of a flat tax rate. The flat tax rate system is also adopted in many countries as a strategy for lowering tax rates and reducing the discriminatory burden placed on savings. The politicians in these countries have resolved about the risk free nature of tax reforms from the success of nations such as Slovakia and Estonia, which were the pioneers. International bureaucracies such as the International Monetary Fund (IMF) have been on the forefront in discouraging tax reductions and reforms that support growth (Mitchell). Most of the countries that have adopted the flat tax rate are also lowering their rates; Estonia, for example, intended to lower the tax rate by half by the year 2011.

Examples of Application of the Flat Rate in Different Countries

Estonia is one of the pioneer countries to implement the flat tax rate. Estonia implemented a 22% tax rate on personal income in 1994. This was a reduction from the original tax rate of 26% that was applied in the country. One tax rate is applied to all income sources for corporate entities and individuals. However, there are two exceptions in the tax rate. The exceptions are 10% rate for benefits from pension schemes and 15% rate for withholding tax on some payments to non-residents. The collection is split between the state and local authorities. The transition to the flat rate system enabled the country solve the problem of inflation, which was affecting the income levels for the different tax brackets. The economy of Estonia has grown by 6% annually since 1994. Government revenue in 1993 was 39.4% of GDP while it was 39.6% in 2002 (The Economist).

The graph shows the tax quotas for the European countries that have implemented flat tax in their countries compared with the European Union countries. The tax quotas for these countries are much lower than the quota for European Union and Czech Republic, which does not have a flat tax system.

Russia is another example of a country that implemented a flat rate tax system in 2001. Before these reforms, the government was suffering from tax arrears amounting to about 34% of the total tax collections. Government revenues were also low, settling at 12.4% of GDP. The biggest enterprises in the country were ignoring almost 30% of their required taxes. They paid 63% of the tax in the form of goods and services supplied to the government. The personal income taxes were broadened in 2001 by collapsing the bands of 30%, 20%, and 12% into a single tax rate of 13%. The result of this was an increase of 26% in revenues raised from personal income tax. Real wages in the country also increased by 12% during the year 2002.

The total revenue collected from all taxes also increased. A study by IMF economists Michael Keen and Anna Ivanova in 2002 discovered an improvement in the compliance of citizens with the tax authorities. This increased compliance resulted in a sharp increase in tax revenues. However, this improved compliance was mainly evident in the higher income bracket. They also noted that the tax reform resulted in an increase of the tax rate for most households, which were falling on the 12% income tax bracket.

US History with the Flat Tax System

The United States has never implemented a flat tax system. However, there have been many proposals by presidential candidates and congressional representatives to introduce a flat tax system in the US. Currently there are two bills presented before congress proposing flat rate tax systems. One of the bills proposes 17% flat rate but has a provision for personal allowances. The other bill proposes the removal of taxation on income and the IRS. The flat tax rate plan has been under discussions in congress by the House Ways and Means Committee since 1997. Presidential candidate Rick Perry proposed a flat tax rate of 20%, which allows for social security while reducing government regulation and spending (Court). Herman Cain, on the other hand, suggests a plan that involves a 9% tax on corporate income, personal income, and sales tax. His plan suggests removal of several tax credits such as child credit, and several taxes such as payroll tax.

Advantages

A flat tax rate broadens the tax base for the economy, therefore, increasing the revenue from tax. This results in greater self-sufficiency of the government and reduction in the budget deficit. This has the effect of increasing GDP growth because of higher level of government expenditure financed by tax. A flat rate tax is also easy to administer resulting in low administrative costs for the government and high rates of compliance by the households. This also results in reduction of tax evasion because of removal of loopholes that could be utilized by households. Efficiency of the tax system is also improved with the use of a flat tax rate system because there is ease of computation. Another aspect of the simplicity of the flat tax system is that all exemptions, credits, and allowances are removed. This results in reduction of loopholes that result in corruption and other forms of evasion.

The flat tax rate is fairer than the progressive tax systems because it removes the use of deductions in the calculation of tax. The value of deductions increases as the income of a person increases; therefore, removal of deductions in the calculation of tax reduces the total tax paid by individuals and households. Lower rates of tax result in stimulation of economic growth, which leads to increased levels of employment. This, in turn, results in equitable distribution of wealth and income. Flat tax rate results in horizontal equity among individuals and households in the economy, which is more equitable than the vertical equity in terms of fairness.

Distortions and incentives in the economy are removed by the use of the flat tax. This is beneficial to efficiency of the tax system. The flat tax system also reduces the possibility of double taxation and reduces the discriminatory tax burden on savings and investment. In light of this, the flat tax increases the incentive for companies and households to save their money and invest. Therefore, the flat tax will result in increased investment in the economy thus increasing GDP growth. This results in higher performance of the economic agents such as corporations because they have an incentive to retain profits and reinvest them for growth of the enterprises (Browning and Browning 632). This means that the implementation of a flat tax system will improve the fiscal climate in the economy thus attracting investments and jobs from other countries. This also reduces the incentive for domestic investors and taxpayers to shift economic activities from the domestic economy to other countries.

Transformation of the income tax system will result in the availability of higher levels of disposable income for households thus lowering the cost of employment. The flat rate also reduces the tax burden on corporation thus creation of new jobs in the economy.

Disadvantages

Economic theory on taxation posits that equity results in reduced vertical equity. The flat tax system is regressive because the tax burden is not distributed equitably depending on the income (Murray 5). Individuals in the lower income groups bear heavier tax burden than individuals earning higher incomes. The use of flat tax rates leads to loss of deductions that are used in the current tax system. The implementation of flat tax would result in a distribution of tax that is different from the current system. People in the high-income bracket will see a decline in their tax bill.

When compared to the present system, the flat tax results in the reduction of opportunities to assist financial needs of the financially challenged. The elimination of deductions and tax breaks will be one of the consequences of the flat tax rate implemented. Charitable donations and mortgage interest will be reduced; the reduction in mortgage interest will be harmful to the housing market. The main incentive for owning homes in the US is the tax benefits, elimination of these benefits will result in deterioration of home prices. Since the implementation of a flat tax rate will be accompanied by reduction of the tax rate, it is likely to result in reduction of the overall tax receipts. Reduction of tax receipts due to implementation of the flat tax will force the federal government to reduce federal government spending or introduce a high rate for the flat tax.

Another disadvantage of the flat tax proposed in the US is that it ignores Medicare taxes, federal excise tax, and social security taxes. However, the payroll tax of 12.4% set aside for social security remains in place. Individuals making over $ 90,000 annually will no longer be required to pay social security tax. State and local taxes will also be left in place, which means that the system will still be complex. However, most of the taxes paid by the wealthy people including tax on dividends, capital gains, and interest. This results in unfairness in the system by reducing the tax burden on high-income groups while retaining the benefits to them.

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