The Tax Foundation highlights the recent rise in states transitioning from graduated to single rate income taxes.
The Tax Foundation focused recently on the rise in states transitioning from graduated to single rate incomes taxes. This begs the question, why now? To get to the answer, we must first understand the context.
The stats from the Tax Foundation are telling about the direction states are taking to simplify tax policy. Since the first state income tax was implemented in Wisconsin in 1912, only four states have ever transitioned from a graduated income tax to a single-rate income tax. As of May 2022, four more states are slated to make the transition within the next four years.
The four states that plan to make the switch to a flat tax in the next four years are Arizona, Georgia, Iowa, and Mississippi. Oklahoma has initiated the legal proceedings to eventually switch as well. This will bring the grand total of states with flat income tax to 13.
If this recent trend keeps up, other states are expected to follow suit. While a flat tax rate does not necessarily mean more or less tax burden for specific individuals and companies, there are multiple benefits to taxpayers that are driving these recent transitions.
13 States have or will have Flat Income Taxes by 2026
Benefits of Flat Income Taxation
Flat income tax rates are simpler on taxpayers and administration and provide certainty that graduated taxes cannot. But what does that mean exactly?
Flat tax rates make forecasting revenue and estimating tax liability an easier process from an accounting standpoint. Also, flat tax rates discourage states from unnecessary tax hikes, creating more certainty for future economic decisions from taxpayers and businesses.
In addition, a flat tax rate makes it easy to compare state tax burdens, which impact operational decisions and expansion strategies. As revenue changes, graduated rates can make it difficult to calculate the true tax burden and make logistical decisions accordingly.
Flat income tax rates are clearly on the rise in the U.S. and, when implemented, can lead to more efficient business operations. Here’s where we circle back to the question, why the greater interest now?
One significant reason might be the impact on interstate commerce. Compliance challenges and related costs associated with state and local sales taxes have a significant impact on interstate commerce. Tax compliance costs can be large and include personnel or tax advisory services, software and systems required to ensure that taxes are properly charged and paid, and the costs associated with handling state tax audits.
When the burden of collecting tax and the associated compliance costs exceed the profits associated with activity in the state, a graduated state tax may impermissibly harm interstate commerce. Under the U.S. Supreme Court’s four-prong test in Complete Auto, state actions and tax systems must meet all four prongs to prevent undue burden on interstate commerce: (1) substantial nexus, (2) nondiscrimination, (3) fair apportionment, and (4) fair relationship to services provided by the state. Thus, a state’s imposition of tax and the duty to collect and remit tax is unconstitutional when it places an undue burden on or discriminates against interstate commerce.
Given the complexity of state and local tax systems, the push for simplifying and standardizing sales tax collection responsibilities to protect sellers from excessive administrative and compliance burdens is proving to be a heavy lift, thereby opening the door to a simpler approach, flat tax rates.
Take, for example, the Streamlined Sales Tax Project (SSTP), under which there are uniform rules, tax bases, and rates in states that sign on. However, the largest U.S. states are not members, including California, Florida, New York, and Texas. Even for states that are members and have standardized definitions, there are still complications because uniform rules may not clearly apply to unique and complex businesses that are responsible for classifying their products and services under these rules.
In addition to the SSTP, states have attempted to simplify the collection of local tax for remote sellers through single-rate elections and centralization rules. In most states, registering at the state level will also register you at the local, city, county, and municipal level. In some states, the tax base for the local jurisdictions is generally the same as the state, and the administration of sales tax may be centralized at the state level— meaning the states will collect and disburse to the local jurisdictions. There are, however, so many exceptions to this general rule that tax burdens rise in the ambiguity.
While the SSTP and many states with thousands of local and home rule jurisdictions have attempted to simplify sales tax administration and filing requirements, many states and their local jurisdictions maintain complex systems. Flat tax rates is any easy way to simplify tax policy fast and with certainty for taxpayers and administrators in a way that upholds the interstate commerce protections.
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Source: Tax Foundation