Minnesota lawmakers beware, a flat tax revolution is underway

The past year has been an especially good year for income tax reform. About half of all states — and counting — have cut their income taxes between 2021 and 2022.

But what is perhaps more encouraging is the fact that more states are also choosing to implement a flat income tax system. As Jared Walczak from the Tax Foundation explains,

Iowa is phasing in a 3.9 percent flat individual income tax by 2026, going from a graduated-rate tax that not long ago topped out at 8.98 percent. Mississippi will have a flat tax as of next year, with a 4 percent rate by 2026. Georgia’s income tax is now scheduled to convert to a flat rate of 5.49 percent, eventually phasing down to 4.99 percent. A court cleared the way for the implementation of Arizona’s transition to a 2.5 percent flat tax, which should happen, pending revenue availability, in 2024. In special session, Idaho adopted a 5.8 percent flat tax, replacing a four-bracket system. Missouri has been called into special session to adopt income tax rate cuts, but a flat tax could still be a consideration, soon if not this session, and a serious effort at adopting a flat tax is likely in Oklahoma next year.

Admittedly, Missouri did not pass a flat tax, but the state still managed to reduce its top income tax rate from 5.3 percent to 4. 95 beginning in 2023. But even without counting Missouri, it is safe to say that a flat tax revolution is underway among the states.

Consider this,

In more than a century of state income taxes, only four states have ever transitioned from a graduated-rate income tax to a flat tax.

But this year alone, five states have switched to a flat income tax system.

Why a flat tax system is better

Apart from the obvious advantage that low taxes bring — namely income and economic growth — there are other benefits associated with a flat tax system specifically.

For one, a flat tax system is easier to navigate, which saves individuals and businesses compliance costs— thereby discouraging evasion and avoidance in some cases. It also saves government enforcement costs.

But even more importantly, a flat tax system is less harmful to economic growth than a progressive tax.

Why is this the case?

Under a progressive system, the more money someone makes, the higher the taxes they pay. People, however, make decisions on the margin. And if the cost of making an extra dollar keeps going up, they are not going to try as hard to make that extra dollar.

Additionally, higher-income individuals are arguably more sensitive to taxes than low-income individuals, so they respond much more strongly to high marginal taxes, either by reducing work and investments or shifting their income elsewhere altogether. High-income individuals are also generally more mobile than low-income individuals, so they can easily escape high taxes.

But even considering how well connected the world is today, people need not necessarily move in order to escape high taxes. They can merely use existing channels to invest their incomes in other cities, states, or even countries, denying high tax regions much-needed capital and investment.

In fact, numerous research papers do have evidence supporting the idea that progressive taxes are much more damaging than flat taxes. In 2021, for example, a paper by the Congressional Budget Office (CBO) found that among three government financing options: a flat labor tax, a flat income tax, and a progressive income tax,

A progressive income tax generates the largest decline in total output. It also generates the smallest decline in consumption among the bottom two-thirds of the income distribution.

As explained, this was because,

high-productivity workers reduce their hours worked and because higher taxes on asset income reduce the incentive to save and invest relatively more than under the two flat taxes

The Tax Foundation has echoed similar findings from their modeling.

Minnesota legislators beware

Tax rates matter, but they are not the only component of the tax system that matters. How the tax system is structured also matters for economic decisions.

A flat tax system with low tax rates is not the same as a progressive tax system with low rates. For income and economic growth, a flat tax system is a better way of collecting revenue than a progressive tax system.

It is encouraging that a lot of states are recognizing this and taking the necessary actions to improve their tax systems. We only hope that Minnesota legislators are taking note lest we are left behind.