What's the difference between a flat tax and a fair tax?

It'd be hard to find anyone happy with our complex tax system. Some are so upset by it that they want to see a drastic reform of the whole tax code. See more ­tax pictures.
iStockPhoto/Jesus Jauregui

­

Most agree that America's current tax code isn't perfect. Many point to tax policy in other nations, saying they have been more effective and the United States is lagging behind. Two alternatives that claim to improve the system have come to the forefront in American politics: the flat tax and the FairTax.

You've probably heard talk of these plans in the media. In the 2000 presidential campaign, Green Party candidate Ralph Nadar supported the flat tax, and in the 2008 campaign, Republican Mike Huckabee threw his favor behind the FairTax. But as you hear names thrown around and see bumper stickers promoting one or the other, you may have been confused about what exactly the differences are between the two.

To better understand how each plan would change things, we first have to know the basics of the current system and the major criticisms of it. As it stands, Americans pay a progressive income tax -- meaning that higher incomes get taxed at higher percentages than lower incomes. Specifically, the current system uses margins -- also known as tax brackets, or ranges of income -- to determine what percentage a person pays. Taxable income can also depend on how much you've earned in capital gains or on specific deductions and exemptions that apply. The federal government taxes a corporation's profits in a similar way.

Ma­ny critics consider the tax code confusing and impossible for the average taxpayer to decipher­ -- often requiring a hired professional. Even the Internal Revenue Service (IRS) Commissioner has admitted that complexity of the tax code contributes to both honest mistakes and tax evasion [source: IRS]. Others go further, saying that the progressive tax system is inherently unfair, as it puts an excessive burden on the wealthy. In relation to this criticism, opponents claim that this burden discourages behavior that would promote economic growth. Were the government to revamp the system to change this, the argument goes, all would benefit from a more prosperous economy in the long run.

Although they both have similar goals and would entail significant overhaul of the current system, the plans differ is some fundamental ways. Whereas the flat tax would tax all income at the same percentage, the FairTax wouldn't tax income at all -- it would instead institute a national sales tax. Next, we'll explain the differences in more detail.

 

Flat Tax vs. FairTax

Steve Forbes famously supported the flat tax in his run for president.
Steve Forbes famously supported the flat tax in his run for president.
Kenneth Lambert/Washington Times/Getty Images

Neither the flat tax nor the FairTax plans are radically new ideas. The U.S. implemented a flat income tax for a short time after the Civil War. Many states and countries use a flat tax today, but the specific plan for the FairTax is relatively new and dates back to the mid-1990s. Did you know that the U.S. federal government relied on sales tax before the income tax was fully enforced with the passing of the 16th Amendment in 1913? To understand how radically different the two ideas are, let's delve into how each would work.

Supporters of a flat tax believe that the only fair income tax would apply an equal percentage to all taxpayers. Specifically, many supporters advocate a rate of 17 percent. In other words, if one person earned $50,000 a year and another earned $300,000 a year, both would pay 17 percent of their income to the federal government. Although flat tax plans do away with most of the exemptions, loopholes and deductions that result in much of the complexity of the current system, many versions include an exemption for families [source: Mitchell]. Advocates say that, with a flat tax, most people could figure their annual taxes on a simple postcard.

The most notable element of the FairTax is that it would completely abolish Federal income and corporate taxes as well as the Internal Revenue Service. Instead, it would institute a national sales tax that would pull in enough to cover all government programs -- taking revenue from what is spent rather than what is earned [source: FairTax.org]. To make sure that the poor don't suffer the brunt of these sales taxes, the government would send a monthly check called a prebate to families that would cover taxes on necessary expenses. The idea is that "no American pays tax on necessities" [source: AFT]. The check amount would be up to the poverty level; a family doesn't need to fall below the poverty line to receive one.

Mike Huckabee speaks at a rally for supporters of the FairTax during his run for president in 2008.
Mike Huckabee speaks at a rally for supporters of the FairTax during his run for president in 2008.
Don Emmert/AFP/Getty Images

The two plans have a lot in common: They both eliminate many forms of taxes and claim to be fairer than the current system. Proponents of both the flat tax and the FairTax say that their plan will improve everyone's situation because it will promote economic growth by eliminating the capital gains tax and double taxation that currently discourages productive activity like saving, investing and job creation [source: Mitchell].

Critics point to many potential transition problems with these tax plans. For the flat tax, people expecting a tax advantage won't get it. For instance, homeowners can no longer expect a tax deduction for the interest on their mortgage [source: Weisman]. For the FairTax, some argue that immediately before we switch over, consumers will buy items on credit without the tax and then pay for the credit for years to come with untaxed income.

In response to these accusations, the Tax Foundation group -- which aligns itself with neither plan -- argues that any problems with transition to the new system are worth the benefits each would produce [source: Hodge].

Neither plan has yet gained enough support in Congress to overhaul the existing system. Time will tell if Americans will see one of these, or perhaps some other plan, take over the unpopular tax code.

Related HowStuffWorks Articles

More Great Links

Sources

  • FairTax.org. "Thumbnail sketch of the FairTax." FairTax.org. [Sept. 12, 2008] http://www.fairtax.org/PDF/FairTaxThumbnailSketch.pdf
  • Hodge, Scott A. "Tax Reform: Flat Tax or FairTax?" The Tax Foundation. Aug. 20, 2007. http://www.taxfoundation.org/publications/show/22562.html
  • IRS. "New IRS Study Provides Preliminary Tax Gap Estimate." Internal Revenue Service. [Sept. 12, 2008] http://www.irs.gov/newsroom/article/0,,id=137247,00.html
  • Mitchell, Daniel J. Ph.D. "A Brief Guide to the Flat Tax." The Heritage Foundation. July 7, 2005. [Sept. 12, 2008] http://www.heritage.org/Research/Taxes/upload/80562_1.pdf