In its purest form, a flat tax means only one tax rate for all levels of income. Income would be taxed once, and only income would be taxed. At a stroke, all the complexity of the tax system would be swept away. All exemptions and allowances would disappear. Everyone would be able to calculate what they owed in tax with the greatest of ease. The simplicity of the system would give everyone incentives to work harder because tax would be a known quantity. Tax avoidance would be dramatically reduced, and the distribution of resources would become more efficient because the distortions created by tax havens and tax lawyers would fall away. The economy would boom, and revenue from taxation would rise. More wealth, more welfare, less hassle: who could possibly dissent?
In the 19th century, taxes on income were flat. Those who paid tax contributed a set proportion of their income. The rich paid more as a proportion but at the same rate as all other taxpayers. In the 20th century, with the great growth in the scope and scale of state activities, flat taxes went out of fashion as many countries introduced forms of graduated or progressive income tax.
As the role at government grew, the rich paid not just more in absolute terms, but progressively more of that part of their income above a certain threshold. Governments needed to collect more revenue, while moral arguments about social justice and fairness justified redistribution of resources through the tax system from higher-income earners to lower-income earners, in order to fund better-quality welfare services for all. Over time, graduated systems of taxation became very complex because governments found it useful to offer tax breaks and exemptions to shape behaviour, promote certain activities, and reward special interests.
By contrast, the idea of a flat tax is rooted deep within liberal ideas about the limits of government, and the need for governments to ensure that everyone is treated the same, with no favours for any special interest. Hayek and others revived these ideas after 1945 by attacking the principle of progressive taxation and the idea of social justice, advocating a return to proportional taxation, and a major reduction in public spending and government intervention. They contested the argument of welfare economists that the marginal value of income for high-income earners was less than for low-income earners.
The flat-tax regime in Hong Kong was celebrated by Milton Friedman as the best way to promote economic dynamism. Until recently, few copied it, but now the idea has found favour in several east European economies, including Russia. They are attracted to the flat tax because they think it makes it easier to collect taxes, and will boost economic growth, entrepreneurialism and inward investment. Germany and the US have begun to discuss the idea, while in Britain, George Osborne, the Conservative shadow chancellor, has set up a commission to report on its feasibility, and the Adam Smith Institute and the Economist have come out in support.
Will the flat tax catch on? In countries with complex fiscal systems and extended welfare states it will be hard. There are too many losers. If the distribution of income and wealth was relatively equal, a flat tax might make sense. But since income and wealth are both highly unequal, the result of introducing a flat tax would mean large increases in tax for the poor and huge reductions for the rich. Since all double taxation would be eliminated, there would be no tax levied on dividends, interest payments or estates. All rentier income would become tax-free and VAT would be abolished, along with all customs and excise duties.
For this to work, either economic growth would have to rise substantially to generate sufficient tax revenues, or there would have to be a very large reduction in public spending. The Treasury estimates that current proposals for a flat tax of 20 per cent would create a deficit in the public accounts of at least £50bn. To protect the poor, there would be a high threshold below which no one would pay tax. But high-income earners would still benefit hugely, and the whole burden of adjustment would fall on middle-income earners, which is hardly a vote winner. The alternative would be to slash public spending. Furthermore, putting in a threshold to protect the poor weakens the intellectual case for a flat tax, since it becomes another form of graduated tax, only with just two tax bands – zero and the top rate. If it is all right to have two bands, why not four (as at present)?
Ensuring that the flat tax does not make many more people worse off than they are now seems essential, given the experience with the poll tax. The idea may be popular, but the reality would not be. What may have more chance of catching on are proposals to abolish particular taxes, such as inheritance tax, recently abolished in the US. They would be justified as a way of eliminating double taxation and making the tax system simpler and fairer. This is perhaps where the next challenge will come.