The Elegance Of The Flat Tax

Commentary, Taxation, Peter Holle

Canada is not a place for revolutions, especially when it comes to public policy.

Some say that timidity accounts for the country’s slow slide down the prosperity scale, as ranked by respected agencies like the OECD. The prospect of a flat income tax at the provincial, and possibly the federal level has therefore caught many off guard.

It’s not a new idea. A powerful examination of its rationale can be found in work done about 20 years ago by economists Robert Hall and Alvin Rabushka at Stanford University. Its practicality has been proven in Hong Kong. A simple 15% flat tax underpins the former British colony’s phenomenal economic growth.

Simplicity is the major virtue of a flat tax regime. A large majority of Canadians regularly tells pollsters they cannot make it to the end of the income tax form without help.

Under a flat tax, a simple short income tax form replaces the bewilderingly complex one we use now. A little old lady with a home computer could do all the work now done by thousands of number-crunchers and accountants. How much do we waste now on navigating the tax maze? For a clue we can look to economist James Payne, an authority on the costs of the American tax system. He estimates that, for every dollar his government collects and spends, individuals and businesses spend another 65 cents in collection and compliance costs.

Another problem the flat tax eliminates is bracket creep, the insidious process through which inflation silently pushes taxpayers into higher tax brackets. According to the Canadian Taxpayers Federation, it allowed federal and provincial governments to silently extract an extra $90 billion in tax revenues ($3.5 billion extra in Manitoba) between 1989 and 1999 without the painful process of officially raising rates. In last week’s federal budget, Finance Minister Paul Martin’s best move was to re-index income tax rates to inflation, thereby eliminating bracket creep within our complicated progressive tax system. That’s all to the good. But you may recall that, only a few years ago, Canadians enjoyed the benefits of indexing, until the Mulroney government cancelled it in 1986. A flat tax would institutionalize this common-sense policy and make it less vulnerable to political tinkering.

Canada’s high rates also discourage people from working. Rather than pay higher graduated rates of tax on the last dollars earned, people rationally choose leisure over working. Highly skilled professionals, for instance, will renovate their homes themselves instead of hiring tradesmen to do it. In pure economic terms, we would all be better off if they spent their time on high-skilled work and purchased services where they have no comparative advantage. Economists call this the “tax wedge”. Using sophisticated analysis, the OECD calculates the cost of the tax-wedge effect in Canada at $.56 for every dollar raised in income taxes. At the federal level, it cost our economy over $42 billion in lost jobs and output to collect about $75 billion of personal income tax last year, more than twice the amount of federal transfers to the provinces.

The flat tax is hardly a partisan issue. The idea has been adopted in Tory Alberta, about to debut a flat 11% provincial income tax. Saskatchewan’s NDP, panicking about the accelerating drain of brains and capital towards its lower-tax neighbour, is moving in that direction also. Federally, the Reform/Alliance party is running with a 17% federal flat income tax proposal.

The most fervent advocate of the flat tax in Canada has been Liberal MP Dennis Mills, who published a book on the topic ten years ago. In The Single Tax, Mills maintained that a flat tax with allowances could be more progressive than a graduated rate system with loopholes. The latter often works to the detriment of the low-income earner, he explained, because that person has little access to the expertise of those who shelter their incomes from taxes. A single tax would bring down the curtain on the clumsy ballet of tax avoidance.

To protect the lowest income earners, most flat tax plans feature a large personal exemption. If that deduction is set high enough, the poorest individuals do not have to pay tax at all. To argue, as progressive tax advocates have, that low-income earners are better off under the present system because they receive some paltry tax credits, is to miss the point. Low earners pay a lot of tax on their first dollars of income in the current tax code.

A high personal deduction also makes the flat tax automatically progressive. Say, for instance, that the tax rate is 25%, and the personal deduction is $20,000. A person making $30,000 will therefore pay $2,500. But the person making double that would pay $10,000, four times as much. Someone who earned $120,000 would pay $25,000, ten times as much. Progressivity advocates need simply to push for a higher rate of personal exemption.

The advocates of tax fairness should consider what is patently unfair about our current tax code. It treats different kinds of income earners in different ways and shreds the democratic principle that governments remain neutral. Why should those who can afford to invest in a favoured sector of the economy be accorded a tax deduction privilege unavailable to others?

The simple elegance of a flat tax makes it worth considering. By eliminating most deductions, it gets the government out of the messy business of favouring politically connected sectors while creating room for large drops in compliance costs and the job-destroying tax wedge in our present progressive system.

The flat tax makes sense, enough to rethink the Canadian aversion to ground-breaking ideas.