An ideal tax system is one that is fair and provides enough revenue for state programs that we all benefit from without being overly complicated. Some people advocate for a flat tax as a way to reform or simplify state tax systems. But what does this really mean? Would a flat tax really improve fairness, maintain adequate state revenues, or meaningfully reduce red tape? The answer is no, and a flat tax is likely to make these problems even worse.
In theory, a flat tax rate means that everyone pays the same personal income tax rate, from the richest CEO to a struggling minimum wage parent. Progressive, or graduated, income tax rates are generally considered fairer because they are based on ability to pay, a venerable and long-established principle in public finance circles that lower-income folks should pay a smaller share of their income in personal income taxes than wealthy people do.
Arkansas, however, already has a nearly flat personal income tax. Although tax rates start out at one percent and go up to almost seven percent, the top rate kicks in at about $35,000. This means that Arkansans making $35,000 a year are in the same tax bracket as people making a million dollars a year. A flatter income tax would only widen the gap between the rich and poor in Arkansas and do little to simplify the tax code or increase long-term state revenue. To have a meaningful and fairer personal income tax, the rates and brackets should be spread out over a wider range of income-with top rate kicking in a level higher than $35,000-rather than being concentrated just at the lower-income end of the spectrum. Adopting a state EITC to reduce the burden on our lower-income taxpayers would also improve the fairness of the personal income tax.
A flat tax is harder on low-income taxpayers
Even when taxpayers pay different personal income tax rates based on a graduated income tax system, it is still common to have wealthy folks paying a substantially lower overall state tax rate than mid- to low- income workers. In fact, this is the case in Arkansas. Even with our graduated state income tax, the top one percent pays about half the overall tax rate as the bottom 20 percent.[i] How is this possible? This happens because lower-income earners end up paying a bigger share of their income to sales tax than well off people do. Folks on a tight budget spend a lot of their paycheck on items like gas, clothes, and groceries, which are subject to sales tax. A single mother on a minimum wage salary might frequently spend an entire week’s pay on a taxable expense like groceries whereas wealthy CEO is likely to spend a higher share of his earnings on other non-taxable services like lawn care, or cleaning services.
In addition to spending a smaller share of income on taxable items, wealthier people are also more likely to benefit from tax cuts like the recent capital gains exemption. Capital gains refer to income from assets like stocks or real estate and are far more common among upper-income taxpayers. Arkansas taxes capital gains income, which largely benefits wealthier taxpayers, at a lower rate than income earned from working a job.
If you take into account the amount of money spent on all taxes, a “flat” income tax arrangement is much harder on low- and middle- income workers because it fails to counteract other imbalances in the tax system. The poorest 20 percent of Arkansas taxpayers, those earning less than $15,000 per year, pay about 12 cents of every dollar they earn compared to about 6 cents on every dollar for those making over $311,000. You can learn more about what it will take to build a fair and adequate tax system for Arkansas families here.
Flat taxes can be complex
A flat tax is not necessarily a simple tax. The sales tax in Arkansas is a type of flat tax, but it is by no means simple. In fact, it has over three times as many exemptions as the Arkansas income tax. Calculating a flat-tax income liability is not much easier than calculating a progressive tax, mostly because switching to a flat income tax does nothing to reduce the confusing array of deductions, credits and adjustments that really complicate the tax code. Many tax code exemptions make good sense for public policy, but some deductions like those based on capital gains income only add complexity to the state income tax code and unfairly benefit wealthier Arkansans.
The 2012 Arkansas tax handbook is 192 pages long and only seven of those pages refer to the individual income tax. All of the other pages refer to a variety of taxes like sales and use taxes, and taxes related to gaming, licensure, and natural resources. There are many complex taxes; enacting a flat personal income tax is not a cure-all for tax code simplification.
Flat taxes are not good long-term revenue generators
All income taxes grow and shrink along with the economy. Those in favor of the flat tax prefer relatively steady revenue sources because a sudden drop in state revenue would make funding crucial programs difficult. However, shifting away from a graduated income tax to avoid inevitable ups and downs of state revenue is shortsighted. Graduated income taxes are likely to be more volatile in the short term, but they generate more revenue in the long term than other revenue raising options like the sales tax (which can unfairly target low-income workers).[ii]
So would a flatter personal income tax really be fairer and easier to administer? Not necessarily, and it could end up hurting the least fortunate among us. Arkansas already has a nearly flat personal income tax. A more fair tax would spread the rates and the brackets over a greater range of income with the top rate kicking in at a much higher level of income. But doing this will cost money and would reduce state tax revenues at a time when our funding for the state budget is already hurting from the personal income tax cuts adopted during the 2013 session. Ideally, we should make other changes to the tax system that would raise the revenue to pay for changes we need to make to the personal income. How do we do that? Check back for more on that from us in the months ahead.