Only four states have ever switched from a graduated-rate income tax to a flat tax in more than a century of state income taxes. Another four states may pass legislation to do so this year, and a fifth state’s planned transfer can now proceed thanks to a recent court decision. In what is already a year marked by a strong bipartisan focus on tax reduction, 2022 ushers in a flat tax revolution.
Colorado replaced its half-century-old graduated-rate income tax with a single-rate tax in 1987, the 75th anniversary of state income taxation. When Utah enacted a flat tax in 2007, it took another 30 years for another state to follow suit. North Carolina followed in 2014 as part of its comprehensive reforms, while Kentucky was the most recent to impose a single 5% rate in 2019. Illinois, Indiana, Massachusetts, Michigan, and Pennsylvania were among the five states that already had flat taxes: Illinois, Indiana, Massachusetts, Michigan, and Pennsylvania.
Wisconsin’s first state income tax, enacted in 1912, had a two-rate structure. Massachusetts had the first flat tax, which went into effect in 1917. Income taxes were in place in five states at the time, with Massachusetts and Virginia becoming the first to do so in January of that year. Between the first progressive income tax and the first flat income tax, only five years elapsed, while 75 years went between the first progressive income tax and the first time it was changed from graduated to single rate. It took more than a century for three states to do so, and three of them did so this year, with a fourth being cleared for the shift by a court decision and a fifth potentially on the way.
Iowa will phase in a 3.9 percent flat individual income tax by 2026, replacing a graduated-rate tax that peaked at 8.98 percent not long ago. Mississippi will implement a flat tax beginning next year, with a rate of 4% by 2026. Georgia’s income tax will now be converted to a flat rate of 5.49 percent, with a final rate of 4.99 percent. A judge has cleared the way for Arizona’s transition to a 2.5 percent flat tax, which is expected to take place in 2024, given revenue availability. In Oklahoma, a flat tax is also being considered.
One of the most appealing aspects of flat taxes, according to supporters, is their simplicity. True, but it’s vital to pause and consider what this means. It’s not enough to say that a single rate is easier to understand than several rates; while this is true, it only tells us so much. The use of tax tables to determine one’s tax due is not complicated.
Flat taxes, on the other hand, are meaningfully simple in multiple respects. A flat tax makes it easier to anticipate income and project the revenue consequences of possible tax changes. Taxpayers can more easily estimate their tax burden and see how it changes under different income situations, which improves tax transparency and may help some economic decision-making. It corresponds better with taxpayer perceptions of tax loads based on headline rates, so that individuals and small businesses may be more attracted to a state with a relatively lower flat rate than a state with a graduated-rate system that would result in similar obligation. Furthermore, because all marginal returns to labour and investment are exposed to the same rate, it simplifies the function by which taxpayers decide whether to work or invest more on the margin.
Flat-rate income taxes, on the other hand, tend to act as a bulwark against unwarranted tax hikes and give better predictability for both individual and company taxpayers. Economic decisions are made on the margin; decisions about investments, labour, or relocation will be made based on the impact on the next dollar of income, rather than the previous ones. Flat income taxes, because of their “all-in” nature, not only entail a lower rate on the all-important margin, but they also tend to be more difficult to raise in the future, whereas highly graduated taxes are more subject to targeted, but sometimes economically wasteful, tax hikes.
Taxpayers appear to understand this intuitively, as seen by the landslide rejection of a constitutional amendment allowing a graduated-rate system in Illinois, despite the fact that the initially proposed tax hike would not increase tax liabilities for the vast majority of voters. They seemed to understand that once the principle was established, larger rates would be created for an increasing number of taxpayers, even if the ramifications for the state’s economic competitiveness were ignored.
This is one of the reasons why states with almost flat taxes should think about completing the task. In Alabama, for example, the existing three-bracket structure delivers only $40 in tax savings when compared to taxing all income at the top rate. Raising the standard deduction would readily give the same progressive advantages while retaining the simplicity, predictability, and stability of a single-rate tax. Mississippi, which is in the process of transitioning to a flat tax, and Oklahoma, where a flat tax is being considered, are two more states with top rates that start at or below $10,000.
These states now offer a chance for reform that could lead to a flat tax, but they also serve as a warning tale about the consequences of not indexing a graduated-rate income tax. The majority of taxpayers were fully exempt when Alabama adopted its graduated-rate income tax in 1935, and only a few were subject to the top marginal rate of 5% on income above $3,000, which is equivalent to nearly $63,500 in 2022, higher than the state’s median household income today and a small fortune in Depression-era Alabama. Because of the lack of inflation indexing, the vast majority of taxpayers’ income has been exposed to the top marginal rate over time. The same can be said for Georgia, where politicians have taken a cautious approach to implementing a flat tax. Since 1955, when it was comparable to nearly $75,000 in today’s currency, Georgia’s highest rate has been set at $7,000 per year.
Five of the nine states with flat taxes have enshrined the advantage in their state constitutions, making it more difficult for lawmakers to raise taxes by moving to a progressive tax system. Because approximately 95 percent of all businesses are pass-through businesses subject to individual, not corporate, income taxes, and the vast majority of pass-through business income is earned by companies subject to states’ top marginal income tax rates, this is a particularly important protection for small business owners. In Illinois, for example, where lawmakers pushed for a failed constitutional amendment to allow a graduated-rate income tax, 93 percent of pass-through business income was reported on returns with more than $200,000 in AGI, and more than half of all pass-through business income was reported on returns with more than $1 million in AGI. Raising the top marginal rate isn’t just for the wealthy; it’s also for the state’s small businesses, and it’s about giving entrepreneurs more certainty when making placement decisions.
States that are shifting to flat taxes, as well as those that have not yet preserved their current single-rate tax schemes constitutionally, should do so. The table below lists states that have enacted or are about to enact a flat tax, along with the date of enactment (past or future) and whether a single rate tax is legally imposed. Four of the five states that have had flat taxes from the beginning have it written into their constitutions. Only one of the four has made the shift.
In 1987, 2007, 2014, and 2019, states switched from graduated to single-rate income taxes. A recent court decision has cleared the way for an Arizona law to take effect in 2021. With new laws kicking off the shift in Arizona, Georgia, Iowa, and Mississippi, 2022 has already seen the enactment or legal clearing of as many new flat taxes as we’ve seen in the history of state income taxes, and that’s before anything happens in Oklahoma.