Flat Tax Explained: Understanding Proposals and Their Impact

I am old enough to remember Steve Forbes’s failed bids for the presidency back in 1996 and 2000, and young enough to have thought that his flat tax plan (which was the cornerstone of his campaign) was a startling new idea.

Seeing new incarnations of the flat tax every four years as the race the White House heats up has cured me of thinking that Forbes had cornered the market in flat tax initiatives. But despite my ongoing interest in money and politics, I found myself still confused by Herman Cain’s 9-9-9 plan and Rick Perry’s flat tax proposal this year. I didn’t know exactly what a flat tax was and why it’s such a favored plan that never seems to be enacted.

What is the Graduated Progressive Tax?

As I looked into the world of flat taxes, I quickly realized that I had no idea how our current system of graduated progressive tax works. I knew there were marginal tax brackets that meant you paid more as you graduated from one to the next, but beyond that, I was at sea. Even after a decade of handling my own tax returns.

A common misconception about our current system (and a misconception that I shared) is the idea that once you move into a higher tax bracket, you pay the higher tax on your entire income. But that is simply not true.

Let’s say you earn $33,000 per year. You are in the 15% tax bracket and pay accordingly. Then you get a great raise one year and now earn $35,000, pushing you into the $34,500-$83,600 tax bracket, which pays 25%. Before you start thinking that you’d rather not have the raise, remember that you will continue to pay 15% on everything up to $34,500, and 25% on anything above that. So your increase in taxes is an increase on the amount you earn over the bracket—that is, on $500—not on everything you earn.

The Basics of Flat Tax Proposals

The progressive tax system is a little confusing, but the goal is to tax people on the money they don’t need to spend. That is, if you’re only making $10,000 per year, a larger percentage of the money you earn needs to go to necessities. Since someone earning $100,000 per year should have no problem paying for necessities, his higher income is taxed at a higher rate.

However, it can feel as though the progressive tax rate might be unfair, particularly to those people earning a lot more, and the strapped middle income earners who feel as though they are carrying both the very poor (who don’t pay much in taxes) and the very rich (who can more easily take advantage of loopholes).

That’s where the flat tax proposals come in. In this scenario, every single taxpayer would pay the exact same percentage of his or her income. The proposals seem to offer a simple and egalitarian method for handling our very complicated system of taxation. Often, proponents of these plans claim that with a flat tax, we could each file our taxes on a form the size of a postcard.

Why We Don’t Have a Flat Tax

There are several reasons why flat tax proposals don’t get farther than campaign promises. For one, instituting a flat tax would not fix the biggest problem with our current system—loopholes. The deductions, credits, exemptions and other aspects of our tax codes that make it possible to reduce the amount of taxable income are more available to those individuals who can pay a tax expert to figure them all out. Creating a flat tax would not get rid of these difficult-to-understand opportunities, and might thereby increase the tax burden on the middle and lower income taxpayers.

Another reason flat taxes have remained a twinkle in a politician’s eye is because the percentage of flat tax necessary to keep the government running would represent a pretty hefty bite out of our incomes. Graduated tax rates try to save those bites for the highest levels of income.

Finally, deciding what income could be taxed is a maddeningly complex decision. How do you tax unearned income, i.e., the money generated from investments? How do you determine the amount that a small business owner should pay when he earned $150,000 in a year but had to spend $100,000 on inventory and payroll?

The Bottom Line

It’s unlikely that I will ever see our system change to a flat tax in my lifetime. Changing our country’s tax code is like trying to steer an aircraft carrier. I do hope, however, that we will always continue the dialogue as it will help us get closer to fairest system possible.

For more answers regarding taxes, check out our complete Tax Guide.

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