It is summer and time to think about vacations, relaxation — and tax reform. This is the time of year when solons in both the U.S. and Guam take up the issue of tinkering with the tax code. The typical impetus is to spur economic growth, employment and sometimes simplification. This can be a daunting task.
The net income tax law is now approximately 80,000 pages long and filled with a myriad of special interest legislation that has nothing to do with raising revenue to run the government. These special interest statutes are meant to influence individual behaviors, morals and other non-tax principles. They also provide significant complexity to the issues of raising revenue and fairness.
When simplification is mentioned, the term “flat tax” is routinely discussed. By removing all deductions and taxing income at a single rate, the tax system becomes something everyone can understand. In its simplest form, this is a flat tax. One tax rate, no deductions. No need for troublesome recordkeeping, tax advisers and worrying about the tax effect of your investment decisions. It is also easier for the government to administer, reducing the work of the tax authorities.
In one form or another, a flat tax has been enacted by many countries in the Balkan area and, more notably, in our region, Hong Kong. Reports from those countries are good. The level of non-compliance has been reduced, and government revenues remained steady or grew after the enactment of a flat tax. Some countries supplement the flat tax system with a gross-based tax, like a value-added tax. In some countries, one or two other brackets with slightly higher rates are added to provide additional government revenue. Some of these countries also enact a separate flat tax on corporate income as well. Flat tax systems do vary from country depending upon the demand for government funding.
By taxing income only one time, the investment capital, or cash, the taxpayer accumulates can be reinvested tax free. This eliminates the need for an estate tax, capital gains tax and tax on dividend income. Only income from wages and business profits are taxed and then only one time. All income earned on these profits and earnings, or capital investments, is not taxed at all.
The proponents of a flat tax see this as the single most important factor for supporting the flat tax system. They argue that when capital can flow freely through the economy without imposition of tax, investments in goods and services will increase and the economy will grow. Foreign investors will be drawn to the simplified system, and more money moving through the economy raises the standard of living for everyone.
Opponents of the flat tax system argue that the burden falls disproportionately on the middle-income taxpayer. The tax rate being the same for both high, middle and low-income tax persons leaves the middle and lower income persons with less disposable income than higher income persons proportionately. The argument is the current progressive rate structure, where tax rates rise as the level of income rises, is a fairer tax system.
To summarize, the flat tax system eliminates all deductions and credits and taxes everyone on the income they earn at one single tax rate. Earnings from investments and other capital saved from income earned is not subject to tax. In this way, there is no need for an estate tax, capital gains tax or a tax on dividends. Income is only taxed once under a flat tax system.
Those countries that have enacted flat tax systems have generally seen an increase in revenues after the change from a progressive tax rate structure. This seems to be particularly true in countries that have experienced significant non-compliance in their old tax system. The flat tax removes the complexity and ability to evade tax that is found under most progressive tax rate systems.
Joe M. Arnett
Deloitte & Touche LLP