financial services

Understanding Flat Tax

Understanding Flat Tax

Tax systems that are followed worldwide majorly fall into three categories –

  • Progressive tax
  • Regressive tax
  • Flat tax

A progressive tax is one which charges the rich more than the poor. Here, the tax-rates increase as income tax brackets go higher, thus financially impacting higher-income individuals and businesses more and low-income earners less.

Regressive taxes affect low-income individuals more than the high-income earners. In this scenario, a tax liability is not imposed directly on the individual’s ability to pay, but the government levies tax as a percentage of the asset that the taxpayer buys. For example, a sales tax on buying an item is assessed as a percentage of the item bought which is same for each individual or entity. Here, a fixed sales tax will have a bigger burden on lower-income earners than it will have on the wealthy.

Flat Tax

Unlike progressive tax regime, where you are taxed more with an incremental increase in the income, a flat tax is a tax system with a constant marginal rate. A marginal tax rate is the tax rate an individual has to pay for one additional unit of income.

Flat tax, in its essence, is a proportional tax. Its application is often progressive and seldom regressive, based on the deductions and exemptions on taxes. It is a proportional tax system because it imposes same tax rate on all taxpayers regardless of regardless of their earnings.

But where deductions are applicable, the flat tax becomes a progressive tax, while the marginal rate on all further income is constant. The difference between a true flat tax and a marginally flat tax can be understood by considering that the latter simply excludes certain kinds of incomes from being defined as taxable income.

A flat tax can also behave like a regressive tax when income is taxed at a flat rate until a specified cap amount is reached.

In economics, one theory supporting flat tax is the Laffer Curve theory which is based on the principle that marginal tax rates will impact the incentive of increased income, meaning that higher marginal tax rates cause individuals to have less incentive to earn more. This explains then how population-wide taxable income decreases as a function of the marginal tax rate, making net governmental tax revenues decrease beyond a specific taxation level.

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