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In Theory

This type of tax is mainly known as a “flat tax”. This is because in a purely proportional taxation system, everybody pays exactly the same percentage with no exemptions. However, in reality, there are many variations on a flat tax. For example, there could be a minimum untaxed income. Or there could be only two flat taxes for two income levels; one for the low and one for the high. Or some exemptions could be allowed. Or the calculations as to what is deductible or what is not. We will analyze this tax as a flat tax since all the other variations are quite close to it and do not affect significantly our logic.

The main argument for this type of taxes is that it will allow governments to increase their revenue by eliminating exemptions. If revenue is increased, then the tax rate can be lowered substantially for all the citizens.

According to government officials (aka government economists) the main reason for low revenue is not that people increasingly refuse to pay, but because of all those rich people are not paying their “fair share” due to tax exceptions and loopholes. If it would be possible to eliminate these, then revenue would rise and taxes could be lowered for everybody!

The perfect solution, rob the cake and let them have it too!. Alas, there are a few tiny problems with this scheme.


Proportional Taxation 


In Reality

The first problem with this type of taxation is to assume that all your revenue belongs to the government and it lets you keep whatever it considers just. If you make use of loopholes or exemptions, you are somehow cheating the government out of its money. We are curious, how do you feel about this concept? Do you agree that the government owns all your money? As far as we can remember, not even the USSR went that far, they allowed a de-facto minimum of private property, typically salaries.

Then we have the issue of paying Peter to rob Paul. If exemptions and loopholes are abolished, those having them will now pay higher taxes, while those who did not have them will pay lower taxes. In other words, such a scheme would pay Peter (whose taxes will be lower since he did not have exemptions) by robbing Pau (whose taxes will be higher because he had tax exemptions). This system is only shifting winners and losers around. Does this make any sense?

Deductions and exemptions are nothing more than ways in which people work hard to prevent the government from robbing them more. Deductions and exemptions are not cheating; they are a last resort self-defense methods to achieve some protection against the illegitimate and insatiable greed of governments!

This type of tax is supposed to benefit more rich people than poor people. This is so because a percentage of a low income means a lot for poor people, while the same percentage of a high income means far less to rich people. If you earn 100 Swiss Francs a day and pay 10 of them as taxes, you are left with 90 which is insufficient for food, clothing and shelter. However, if you earn 100,000 Swiss Francs a day and you pay 10,000 of them as taxes, you are left with 90,000 which is abundantly sufficient for food, clothing and shelter (plus many extras). Alas, economists are not taking into consideration that rich people are allowed to keep more of their money than in a progressive system As such, they invest more and therefore the economy reaches a higher level; and with it, higher standards of living for all. This includes poor and rich alike. So, paradoxically enough, a flat tax is less damaging than a progressive tax although poor people are taxed more!

The flat tax also has a gigantic advantage for governments: it is ruthlessly efficient. Almost all taxation is collected at source. This means that all taxes have already been deduced from your income when you receive it. All companies have become de-facto tax collectors. At the same time, since you never receive your money in full, it is almost impossible to make use of any deductions, exemptions or loopholes. Furthermore, this type of tax is usually charged on gross income, not net income. In other words, taxes are calculated on all your income before deductions and expenses (if any are allowed). In the current system, if you earn 1000 Euros and you are allowed 100 Euros in deductions, you are taxed on 900 Euros. In a flat tax system, you are taxed on 1000 Euros and your 100 Euros worth of deductions are dismissed. Not only you pay more, but it is impossible for you to defend yourself against the government. This is the main reason why this is the favorite taxation scheme of dictators and populist governments, particularly in developing nations in Latin America and Eastern Europe. You can see the long list of affected countries in Wikipedia Flat Tax. A secondary reason for the preference of this type of taxation system is that governments can push beyond the optimum in Laffer’s curve and so cheat it. They can extract more revenue that would normally be possible. We have talked about the Laffer curve and how it operates in the lesson The Sweet Spot Of Taxation.

Part of this streamlining, is that enforcement becomes much simpler since calculations become trivial. Enforcement can be delegated to the police with little or no accounting or taxation skills. Which means that persecution and prosecution becomes rampant and endemic.

Another problem of such a flat tax is that taxes are embedded in all products and services at the source. If these products and services are exported to other countries, it is not possible to reverse or remove those taxes. Consequently, exports become less competitive and the economy slows down with the accompanying drop in standards of living.

Lastly, we have the issue that this type of tax is supposed to be similar to market pricing. Same as the previous type. However now the excuse has been improved. The notion is that in the marketplace everybody pays the same price and so everyone pays the same percentage. Fair, right? The problem is that this argument keeps ignoring the fact that the market prices items according to value, not income! Contrary to what it may seem, a proportional tax is still proportional (not flat), although it may be less damaging than a progressive one from this point of view. Enough nonsense already?

Note: please see the Glossary if you are unfamiliar with certain words.

Continue to Taxes And Myths - Part 4


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