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Flat vs. Value-Added Tax: Definition & Examples

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.

Just like there are different types of economies, there are different types of taxes governments can use to collect taxes from the economy. In this lesson, we'll discuss two common types of taxes: a flat tax and a value-added tax.

Introduction

There are many different types of taxes. Even within the same country, there are different ways consumers and businesses are taxed. Sometimes it is through a use tax, where only the consumers of a certain good or service are taxed, such as the tax included in the cost of each gallon of gasoline. When it comes to a general tax, the debates start about which method is best. In this lesson, we'll just discuss two of the most common - a flat tax and the value-added tax.

The Flat Tax

A flat tax is a tax system where everyone with any income, regardless of the source of that income, is taxed at the same rate. While income from work is the most common source of income, people also make money from interest on savings, dividends or capital gains on investments, gifts or inheritances, and a number of other ways. In many tax systems, each of these sources of income is treated differently and taxed at a different rate.

A flat tax also eliminates the concept of tax brackets, or ranges of income. Tax brackets are part of a progressive tax system, where those in higher tax brackets are taxed at a higher rate than those at a lower tax bracket. Tax credits and deductions are also eliminated in a true flat tax system. A tax credit, such as the child tax credit in the U.S., gives the tax payer a certain dollar amount to put towards their tax bill. So, if someone owes $3,000 in taxes and then receives a $1,000 tax credit, they only owe $2,000. Deductions lower the total amount of income the appropriate tax rate is applied to. If someone makes $52,000 but has a $12,000 standard deduction, then they only pay taxes on $40,000 of their income.

Those few terms and calculations are all moot in a true flat-tax system. In a flat-tax system, if the tax rate is 10%, then whether someone makes $20,000 per year for a family of six, or $800,000 a year as a single person, they are taxed at 10%. Some people believe that a flat tax is the fairest tax system, because everyone pays ''their fair share.'' In some sense, that's true - everyone is paying the same relative amount of taxes - 10%, or wherever the tax rate is set.

Others, however, believe that the flat tax puts an unfair burden on people who have less income. At first glance, this might not seem possible, but after some quick math, we can see their point. Imagine Steve is a young, single father of two and makes $24,000 per year. Basic standards of living (rent, food, basic healthcare, etc.) for a family of three in his area is $2,000 per month. Well, he makes $2,000 per month, but after the 10% tax, he only brings home $1,800 - so he is $200 below the standard of living.

Tracie, on the other hand, is a single mother of two, but makes $120,000 per year. She lives in the same place as Steve, so has about the same costs, and with the 10% tax rate, she brings home $9,000 per month. So, while Steve is only paying $2,400 in taxes and Tracy is paying $12,000 in taxes, Steve lives $200 below the standard of living and Tracy lives $7,000 above the same standard. The question of whether that is fair or not is an individual opinion, but it's the type of situation policy makers need to think about when making tax decisions.

Value-Added Tax

While the flat tax is a tax on income, a value-added tax is a tax on consumption or sales. But, unlike a sales tax, it is assessed at each stage of the production process, not just when the consumer buyers the good. The value-added tax, or VAT, is a tax system common in Europe and other industrialized countries outside the United States. This will make a lot more sense with an example.

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