If you dread filing your taxes every year, it’s good to know there are multiple taxation systems besides the current progressive one here in the United States.
If you’ve heard the terms “flat tax” or “Fair Tax” then you may be wondering what they are.
You may also be wondering how they differ from a progressive income tax and why people may want another system.
Look no further. We’re going to explain it all!
Progressive Income Tax
The difference is clearest once you get a handle on what the current progressive income tax is. Progressive means the tax rate climbs as income does. Under a progressive tax system, people who make more are taxed at a higher rate than those who make less. So, if someone makes $500,000 in salary, they will be taxed at a higher rate than someone making $50,000.
The theory behind this is simple: A progressive tax system is thought by its proponents to be fairer to all income groups across the board. Someone making $50,000 may pay a relatively higher percentage of their salary on basic necessities like food and shelter than the typical millionaire earning a $500,000 salary.
This is especially true if that $50,000 salary supports children or pays for medical treatment that results in large healthcare bills. The idea is that a lower tax rate allows more disposable income for people in the middle and lower brackets. In the higher brackets, people have more disposable income after the necessities of life are taken care of. They are, therefore, able to pay more taxes.
Those dissatisfied with the progressive tax think it’s unfair to those in higher tax brackets because they pay more not just in dollars, but in percentage of their income.
The progressive tax system is also criticized for being complicated and cumbersome. Most progressive taxation systems, including those in the United States, allow a number of exemptions and different rates for capital gains and investments. Alternative systems are praised for being less complicated.
A progressive tax system is among the most common around the world; it’s the system of choice in countries such as the United States, Canada, China, Japan, Germany and Australia.
The Flat Tax
In some ways a flat tax system is the opposite of a progressive income tax. The flat tax, as its name implies, is simply one flat tax rate. It applies to everyone, regardless of income. If the flat tax is set at 17% of income, both the $50,000 and the $500,000 salary earner would pay 17% of their respective salary.
The flat tax is praised by its proponents for being truly fair and consistent. Everyone pays the same percentage of their earnings.
Flat tax proponents also like its simplicity. With most flat tax proposals, there are no exemptions or deductions. Returns can be done on a postcard. Many observers believe the Internal Revenue Service could be eliminated if a flat tax were enacted.
Detractors of a flat tax say it places an unfair tax burden on the poor. Someone making $10,000, for example, would pay $1,700 in tax, which is more than they would likely pay under a progressive tax. Flat tax critics point out their disposable income for necessities may end up being very low.
The Fair Tax
The Fair Tax is significantly different from both a progressive income tax and a flat tax. Rather than a system, the Fair Tax is a specific plan — but unlike the latter two, it’s not a tax on income at all. Instead, it only taxes spending via a national sales tax.
Proponents, such as one-time presidential candidate Mike Huckabee, believe the Fair Tax is fair to all income levels because people are only taxed on their purchases; and spending is entirely under their control.
The Fair Tax avoids disproportionately impacting the poor’s disposable income by including a “prebate” for lower-income folks to purchase necessities like food and shelter; the prebates would not be subject to the Fair Tax.
Proponents also believe the Fair Tax would eliminate complicated and costly income tax filings because there would be no deductions or exemptions.
However, critics believe collecting taxes would be more complicated because the burden of collecting appropriate tax revenue would fall on individual businesses rather than the government. As a result, it might be difficult to ensure uniformity and correct tax collection across the system.
As the 2018 election cycle heats up, keep the pros and cons of each tax system in mind, as they’ll likely be bandied about by those looking for leverage to maintain competitive seats in the House and Senate.
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Anum Yoon is the personal finance blogger who started and maintains Current on Currency. You can catch her on Twitter to follow her updates.
Photo Credit: DonkeyHotey