There’s a recent uptick in states swapping tiered income taxes for a flat tax, charging the same rate to all residents, regardless of earnings.
Over the past 100 years, only four states have changed from graduated rates to flat taxes, according to the Tax Foundation. Another three states — Iowa, Mississippi and Georgia — passed legislation to make the shift this year.
Arizona cleared the way after a recent court decision, and Oklahoma is eyeing the move to join nine other flat tax states.
These changes come amid a wave of state-level tax cuts triggered by budget surpluses. Fueled by better-than-expected revenues and billions in federal support, the windfall is expected to continue into fiscal 2022, according to the National Association of State Budget Officers.
“States are flush with cash,” said Jared Walczak, vice president of state projects at the Tax Foundation. “They’ve seen revenues continue to rise and there is an opportunity for tax reform.”
Many policymakers favor flat income taxes because they see them as simpler, more competitive and harder to change, he said. A single tax rate is more difficult to increase than a graduated rate because it affects everyone rather than specific segments of taxpayers.
Walczak said the decision is particularly relevant for small businesses. Owners often have so-called pass-through income, with earnings flowing through to their individual tax returns, and may have a large portion of their income subject to the top marginal rate.
“With the amount of revenue that policymakers are seeing right now in their forecasts, many see this as a good opportunity to adopt the flat tax reforms they may have desired for years,” he said.
It’s not about simplicity. It’s about tax relief for higher-income householdsRichard Auxiersenior policy associate at the Urban-Brookings Tax Policy Center
While states like Alabama, Idaho and Missouri have yet to propose a flat tax, future legislation may be easier with relatively low earnings thresholds to reach the top rate, Walczak said. For example, in Alabama, the top rate of 5% kicks in once income exceeds $3,000.
However, critics say the benefit of a flat tax primarily helps the wealthy and may create future revenue challenges.
“It’s not about simplicity,” said Richard Auxier, senior policy associate at the Urban-Brookings Tax Policy Center. “It’s about tax relief for higher-income households.”
A flat tax may have long-term negative effects on state revenue, particularly with a shaky economy, he said. Fiscal 2022 revenue may be weaker than expected and some forecasters predict a bleaker outlook for 2023, according to the Tax Policy Center.
The period of inflation, possible monetary policy changes, the war in Ukraine and other factors may have “really negative effects” on future state tax revenue, Auxier said.
“When you create that really low flat tax, you’re tying the hands of your revenue system,” he said, explaining it may be hard to recoup lost income during an economic downturn.
