What is a flat tax on income?

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In a Nutshell

A flat tax is a single income tax rate that applies to all taxpayers, regardless of their income levels. The U.S. has had a federal flat tax on income in the past, and some states currently have one. There would be both benefits and drawbacks to a flat income tax on the federal level.

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This article was fact-checked by our editors and reviewed by Rachel Weatherly, tax product specialist with Credit Karma Tax®.

A flat income tax rate could simplify the tax system — but it could also put an unfair burden on lower-income taxpayers.

The U.S. is no stranger to a flat tax — the country has enacted a flat federal income tax twice in its history. Nine states currently have a flat tax rate on all income and two additional states have a flat tax on interest and dividend income only. And with the current tax code as complicated as it is, some politicians have called for a new federal flat income tax.

But while a flat tax system may appear simpler than a progressive one, it would also likely have some downsides that could make things more difficult for certain taxpayers. Read on to learn more about how a flat-rate income tax works and how it might affect you.



What is a flat tax?

As the name suggests, a flat tax is a single tax rate assessed on all taxpayers, regardless of their income levels. For example, Social Security and Medicare taxes are flat taxes, charging 12.4% and 2.9%, respectively. For both taxes, the rate is split between employers and employees.

The current progressive system

The U.S. federal income tax, however, follows a progressive tax system. In the current tax code, the federal income tax rate increases along with taxable income. The idea is that high-income taxpayers have a greater ability to pay than low-income taxpayers.

For the 2019 tax year, the tax code has seven tax rates — 10%, 12%, 22%, 24%, 32%, 35% and 37%. Each rate corresponds to a tax bracket.

A flat tax rate eliminates the need for a tax rate schedule and tax brackets, which could make it easier for taxpayers to calculate their taxes owed and file their returns.

States with flat taxes

As of 2019, 11 U.S. states have some type of flat income tax rate.

State Flat tax rate
Colorado 4.63%
Illinois 4.95%
Indiana 3.23%
Kentucky 5%
Massachusetts 5.05%
Michigan 4.25%
New Hampshire 5%
North Carolina 5.25%
Pennsylvania 3.07%
Tennessee 2%
Utah 4.95%

 

Note that both New Hampshire and Tennessee tax interest and dividend income only, and not W-2 wages. In Tennessee, the tax will decrease to 1% in 2020 then be fully repealed in 2021. And in Illinois, the question of whether to retain the current flat tax system or replace it with a graduated income tax system will go before the state’s voters on the November 2020 ballot.

How to file state tax returns for free

Why is this important?

The U.S. has had a flat tax rate twice in its history. The first federal income tax was put into place in 1861, and it was a flat tax. At the time, the government was looking for ways to raise money for the Civil War. The tax was repealed in 1872. Then Congress enacted a flat federal income tax again in 1894, though it was repealed a year later when the U.S. Supreme Court ruled it unconstitutional.

A handful of presidential candidates have proposed in recent years to replace the current progressive federal income tax system with a flat tax. As of May 2019, there are proposed bills in both the Senate and House of Representatives calling for tax reform that would replace the current progressive system with a flat tax system.

While it’s unclear how far those tax proposals will go in Congress, the conversation still continues on whether a federal flat income tax is right for the U.S. By understanding both the benefits and drawbacks, you can have a better idea of where you stand on a flat tax and how it can impact your tax burden if it ever happens.

Pros and cons of a flat tax system

As with many potential changes to the tax code, a flat tax rate comes with both advantages and disadvantages.

Pros

Proponents of a flat tax typically cite some benefits of the IRS switching away from its current progressive tax system. For one thing, flat tax supporters argue the system would be fairer because everyone would pay the same rate.

Some who support a flat tax argue that it could also promote economic growth because taxpayers would be incentivized to earn and invest more money.

To provide for low-income earners, some proposals have called for an exemption amount that isn’t taxable. If, for example, the exemption amount is $35,000 and your income is $50,000, you’d only pay a flat tax on $15,000 — the amount by which your income exceeds the exemption amount. And if your income is below the exemption amount, you won’t pay anything at all.

Some flat tax proposals include closing certain tax loopholes for individuals and business owners to simplify the tax code further.

Cons

A progressive personal income tax can help equalize wealth in a country by taking a larger share from high-income groups and effectively giving a tax break to low-income groups.

But that doesn’t work with a flat income tax rate. In this scenario, any tax revenue the IRS loses through a lower rate on high-income earners must be made up by low-income earners.

In 1992, the Congressional Budget Office simulated the effect a flat tax would have on the after-tax income of American families. The CBO found a flat tax would increase the after-tax income of the highest earners by nearly 7% and decrease the after-tax income of the lowest earners by nearly 22%.

How could this affect my taxes?

As with any aspect of the tax code, the effects of a flat tax on your federal income tax obligation would depend on a number of factors. For example, a 15% flat income tax could provide for a cheaper tax bill for a high-income earner with a marginal tax rate of 22%.

But if you’re a low-income earner with a federal tax rate of 10%, a 15% flat tax could increase your federal tax bill.

In addition to your income and effective tax rate under the current progressive system, other variables include exemption amounts, deductions, credits and others. In other words, a flat tax isn’t as straightforward as you might think, and it could take a lot of number-crunching to find out how it would affect you personally.


Bottom line

According to the Brookings institute, total federal revenues, adjusted for inflation, fell from fiscal year 2017 to fiscal year 2018 – the first year the Tax Cuts and Jobs Act of 2017 took full effect. If the federal government looks for ways to offset any loss of tax revenue, a flat income tax might not be entirely out of the question – especially since the U.S. has had one in the past.

It’s important to understand both the positive and negative potential impact a flat tax could have on you and the people around you. As you compare both a progressive and flat tax system with your situation in mind, you can get a good idea of whether it could increase or reduce your tax bill each year.


Rachel Weatherly is a tax product specialist with Credit Karma Tax®. She studied accounting and finance at Western Carolina University and has also worked as a tax analyst. You can find her on LinkedIn.