This article was included in the Carnival of Personal Finance #255.

Every now and again, Larry MacDonald posts another article proclaiming the need to move to a flat tax. He's certainly not the only proponent of a flat tax, but he's the only one that I read. His reasoning for liking a flat tax is its supposed simplicity. Others who find themselves in the highest (or even second highest) tax bracket expect that a flat tax will personally save them money.

Tax Simplicity

Simply put, the complexity of your tax return has nothing to do with paying progressive taxes. The impact of progressive tax on your return is limited to the section on Schedule 1 shown below, and a similar provincial version. A flat tax would consolidate 4 columns into one, that's it, that's all. In any event, the form is designed so that you only have to fill one of the 4 columns, so a flat tax wouldn't even save you much writing.

For the most part, the complexity of your tax return is determined by the number of credits and deductions available to you. Some of these are necessary - if you have self employment income, eliminating all the complexity would have you pay tax on your gross business income, which I doubt anyone would enjoy. Alternatively, we can simply tax net income as determined through GAAP style accounting...which many self-employed individuals would probably like. But those of us who make most of our money through regular employment probably wouldn't appreciate it, as it allows for more abuse in the mixing personal and business expenses, as GAAP is much less rigid than the tax code - this would shift the tax burden onto those with normal, T4-reported, income.

With investment income, we could simplify the return by not allowing you to write of interest on margin accounts, broker fees, and other costs of investing. We could eliminate the dividend tax credit, leaving us the choice of either double-taxing dividends (once at the corporate end, and once at the personal end), or shifting the tax burden from foreign investors onto domestic investors by making dividends tax-deductible in the hands of the corporation.

Eliminating social policy credits, such as the public transit credit or the spousal credit transfer available to married couples with only one income (and single mothers), would reduce complexity, as would eliminating medical credits (80% of the time I spend on my taxes is spent on calculating medical credits...and usually only gets me $20-$100 for my trouble). These, of course, are the types of credits that most people receive, and would therefore be politically difficult to remove. It also brings up a fundamental philosophical question of whether the government should use the tax code to align the profit motive with the public interest. I think this is a good use of resources, others may disagree.

These are the legitimate way to reduce tax complexity. It will work. But as you can see there is always a trade off. For the most part, it's been my observation that people would like the lines that other people use removed from the tax form...not the lines that we ourselves use.

Saving Money

There is no doubt that some people will save money by a switch to a flat tax. But if the government needs to raise the same amount of revenue under either system, then someone else needs to pay more, it's pretty simple math. There's a few different ways to set up a flat tax to decide which group wins and loses in the system change. Holy Potato has a pretty good explanation of these options.

Option 1 - a simple percentage of every dollar earned

Currently, those near the bottom of the income distribution pay little to no tax. Charging a flat tax on every dollar will introduce a tax on the most vulnerable in society who never before had to pay. Likely, this won't raise enough money to covered a significant reduction at the top end, either, and the flat tax rate will be set in such a way that many who already pay a little tax will have to pay more.

Option 2 - a flat tax for all income above a tax floor

The way Alberta has implemented this is through an increase in the Personal Tax Credit that everyone has available to them. Now there is lost tax income at both the top and the bottom of the income distribution that has to be made up by the people in the middle.

Option 3 - like option 2, but with a very high tax floor

When income taxes were first introduced, only those with relatively high incomes paid any tax. This option would return to that system, charging those near the top of the income distribution more than they currently pay, in order to completely eliminate tax for the majority of Canadians who fall into the lower and middle class. I might enjoy this tax holiday, but giving the majority of Canadians a free ride would probably push for a spiraling, ever larger, amount of public services...something most proponents of a flat tax would be unimpressed with. It's likely to also lead to a flight of capital from the country as the wealthy look to protect their wealth.

The Proof

I've been trying to set up an accurate model for this, but not being an academic who does a lot of modeling, I haven't been doing so well. The simplest method is comparing Alberta to Ontario, two provinces with similar wealth levels and a similar amount of revenue raised through income tax (proportional to the size of their economies). While this is a workable comparison, similar is not "exactly the same," so while it's a reasonable stand-in, it's not precisely valid as a comparison of a flat tax to a progressive tax. Still it's what I'm going with for now.

As you can see, if you earn between $25k and $154k, you will pay less income tax in Ontario. (You will pay more sales tax, though, since Ontario doesn't get as much in resource royalties). This isn't some fluke, this is because the flat tax is structured to spread the tax burden around in the vast middle, instead of concentrating it near the top. The majority of people do not benefit financially from a flat tax.