Flat tax: The ultimate in simplicity?

How do we reduce complexity in the tax system? Some think a flat tax is the answer. But is it really? Or is this more a matter of “be careful what you wish for”?

This article explores just some of the potential pros and cons of a flat tax and does not represent CPA Canada policy. Send your feedback to taxmatters@cpacanada.ca.

Canada’s Income Tax Act has mushroomed in volume and complexity since personal income tax was introduced in 1917 as a temporary measure to help finance the First World War. And for decades, the issue of how to simplify the tax system has been debated.

Some advocates think the answer is a flat tax, which sounds simple enough. In its purest form, everybody would pay the same rate on all sources of income.

But can a modern tax system be reformed so easily? Or is such a seemingly simple solution an illustration of the old adage “be careful what you wish for.” Could unforeseen negative consequences outweigh the positives?

“I see this as being part of a bigger discussion around tax reform in general,” says Bruce Ball, national tax partner with BDO Canada LLP in Toronto. He notes how, for instance, successive governments have tended to add many new credits into the tax system, while removing very few.

“From an individual taxpayer’s perspective, a flat tax is obviously much easier to understand and deal with,” says Everett Colby, a principal with Colby McGeachy Professional Corporation in Almonte, Ont.

A pure flat tax of, say, 10 per cent across the board could also be the ultimate in terms of tax simplification.

TAX CODE COULD BE A SINGLE PAGE

“The Tax Code could basically be a single page. All income, no matter what the source, pays 10 per cent – period. Not half the gain, or the ability to defer the gain,” says Colby. “All the CRA needs to do is to ensure that you have a proper description of what constitutes income. That’s it.”

But a flat tax would also entail enormous changes, which some might perceive as disadvantageous.

For example, governments in modern industrialized countries are perceived as using their tax codes as an important lever to incentivize desired social and economic behaviours and outcomes. A pure flat tax could sharply curtail this perceived power — and some might say responsibility — leaving government only with the task of having to set tax rates.

Colby cites examples of economic and social incentives established through the tax system, including Registered Retirement Savings Plans, which provide a tax deduction upfront, and the ability for investment income to compound on a tax-deferred basis, as an incentive to save for retirement. In the U.S., qualified people can deduct their mortgage interest as part of a government effort to promote home ownership.

“You will likely lose many activities that are designed around the Income Tax Act and saving taxes,” warns Colby. “You will also potentially cut many jobs because these tax activities or the administration of the tax law itself becomes so simple. The net result is you’re likely going to cut many financial activities, because you need these incentives to get people to take action. In a flat tax system, there’s no incentive to do anything.”

Ball, however, sees a potential advantage to detaching social objectives from Canada’s tax system. Ideally, he believes, the priority of a tax system should be to raise money in the best way possible, and from the appropriate places, in order to maximize the economy’s potential. Social issues would be addressed outside of the tax system.

“I think the problem is once you introduce more of the social issues into the tax system, you have trouble telling whether it actually has the impact that you want,” says Ball. “An example is the transit credit — does it actually result in more people taking public transit? You might be able to better monitor the effectiveness of some of these things if you did it outside the tax system.”

CRITICS VIEW SINGLE RATE AS REGRESSIVE

There are also questions about whether a flat tax may end up being regressive. The conventional wisdom is that having everyone pay the same amount of tax will disproportionately hurt poorer Canadians.

Ball says that can be prevented by supplementing a flat tax with basic personal exemptions. For example, Alberta had a single 10 per cent flat tax for individuals, along with a fairly large personal exemption, which eliminated tax for lower income individuals.

In June 2015, however, Alberta’s new NDP government introduced a gradual progressive personal tax of 10 per cent on taxable income of up to $125,000 and up to 15 per cent on taxable income of $300,000 or higher. The new progressive tax took effect in October 2015.

But contrary to popular opinion, Colby thinks a flat tax should help reduce the perceived gap between what the rich and middle class pay in taxes. In a flat tax system, not only would the wealthy pay the same rate of tax on a larger pool of income, says Colby, they would lose the ability to mitigate their tax situation if current incentives, like special capital gains or dividend investment income treatment, were taxed in the same manner as regular income.

A common complaint from flat tax advocates is that the current progressive rate tax system reduces work incentive because more tax is payable as soon as individuals move into a higher tax bracket.

“In theory, I guess if you’re taking more money from people at higher levels of income, then there’s a disincentive to actually grow your income,” says Ball.

“But the flip side is that, as long as the progressive top rate isn’t so substantial that it would eliminate the benefit of working, people will still try to maximize their income if that’s what they want to do,” he adds.

There are many ways of interpreting the impact of a flat tax in a modern, complex economy. But as the first centennial of Canada’s Income Tax Act approaches, one thing is certain: any flat tax proposal would have to clear significantly more hurdles than the earliest advocates of personal tax could have envisioned.