What is flat tax?

A flat tax system is one that charges a single marginal tax rate above the personal allowance. This means that above a certain level, everyone pays the same proportion of their income regardless of how much they earn.

It can also describe a tax system that applies the same single rate across a number of different taxes, such as income tax, corporation tax and VAT.

What is the UK’s current tax system?

The UK has a progressive income tax system, which has four different marginal tax rates depending on how much you earn. There is a personal allowance of £4,895 on which no tax is paid, then there is 10 per cent payable on the next £2,090, then 22 per cent on the next £30,310 and finally 40 per cent on all earnings above £37,295. In addition, National Insurance Contributions are payable.

Which counties have flat tax systems?

Ten countries have flat tax systems, all bar one of which are the former communist states of eastern Europe. In 1994, Estonia was the first of these countries to introduce the system with a flat tax rate of 26 per cent. It has since fallen to 24 per cent.

Its Baltic neighbours Latvia and Lithuania introduced similar systems in 1995 and since then Russia, Serbia, Slovakia, Ukraine, Georgia and Romania have all followed suit. Of these Russia has the lowest marginal tax rate of 13 per cent on all income above 4800 roubles - roughly £100. Hong Kong is the only other country with a flat tax system.

What are the arguments in favour of a flat tax

The simplicity of a flat tax system is the most indisputable benefit. It is very easy for everybody to understand and avoids the complexity and potential confusion associated with systems such as tax credits in the UK.

Libertarian exponents of flat tax also argue that it is fairer for everybody to pay the same rate of tax. But the system also has the support of some on the left because low income earners would not have to pay tax at all. Of course, the extent to which the poor benefit depends on the level of the personal allowance. George Osborne, the Conservative finance spokesman, has touted a figure of between £10,000 and £12,000 for the UK.

It is also argued that the lower marginal tax rates associated with flat tax systems encourage enterprise and boost growth as more people enter the labour force and work harder because less income is taken in tax.

An associated benefit is that government tax revenues could potentially rise as a result. Supporters point to Russia where revenues from income taxes have risen by 50 per cent above inflation since the government introduced its 13 per cent flat tax in 2001. However, critics question how much this revenue growth is to do with the tax system and how much can be explained by high economic growth.

A final benefit attributed to flat taxes is that tax evasion falls, particularly among the rich as they no longer have to pay punitive rates of tax.

What are the arguments against a flat tax?

Critics of flat tax systems argue that many of the benefits are not yet proven and that the system is just a way of helping the rich pay less tax. There is certainly no conclusive evidence that yet proves flat taxes increase government revenues or boost growth.

There are also question marks over whether flat tax systems would have the same benefits in the mature and developed economies of Western Europe that they appear to be having on the transitional economies of former communist countries.

Another potential problem with flat taxes are that many of the claimed benefits would only arise if the marginal tax rate was set sufficiently low and the personal allowance sufficiently high. It would be difficult for the government to do this without risking a large budget deficit or to calculate that rates that would be revenue neutral while still achieving the desired benefits.

Some on the left also argue that taking low earners out of the tax system by substantially increasing personal allowances would stigmatise the poor as non-contributing members of society.

Critics also argue that flat tax systems encourage tax competition between countries and that this puts continual pressure on government revenue and therefore welfare and public spending.

Explore Economics

• Autumn Budget 2007

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• World Economic Forum

• The Times MPC

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