I was born in Romania, the most recent country to implement a flat tax rate, at the beginning of 2005. As Confucius said: ‘Things should be as simple as possible.’ I am going to try to show that the flat tax rate achieves all the aims of a fiscal system through the application of a very simple idea.
As a general principle, a flat tax rate is supposed to tax all income once, and only once, as close as possible to its source. For individuals this means that the flat tax is levied on income – whether from wages, salaries or pensions - minus a personal allowance. That is all an individual has to worry about when completing their tax forms.
For companies, the same principle holds. A flat tax is levied on total revenues minus the cost of purchases of imports from other firms, which have already been taxed, wages and pensions paid to workers, and purchases of equipment.
It is really a consumption-based tax because savings and dividends are not taxed and it gives the individual a 100% right to any investment. Everything taken out of the economy is taxed, and everything that is invested or reinvested is not taxed.
Over the last ten years in Eastern Europe, nine countries, starting with Estonia in 1994, have adopted a flat tax rate. The single tax rate has not been uniform across these reformist nations, ranging from 33% in Lithuania to as little as 12% in Georgia. There is a clear tendency, however, for the more recent converts to the flat tax system to set the level at rates below 15%. Of the six nations to introduce a flat tax since 2000, none has ventured over the 20% mark. This downward trend has important implications for theories of tax competition.
Why has this occurred in Eastern Europe? After the fall of communism the whole region was confronted with a myriad of problems, ranging from a lazy economic environment to a massive underground economy and a lack of foreign investment. The flat tax has proved to be a solution to all these difficulties.
It was relatively easy for these countries to introduce a flat tax system because of the vacuum left behind after years of communist rule. For developed economies such as the UK and France, such a switch would prove more complicated owing to their highly complex tax codes.
Economists talk about horizontal equality and vertical equality. All horizontal equality means is that people on the same salary should pay the same amount of tax. It should not matter how you fill out your tax form or how creative your accountant can be in exploiting loopholes in the tax system. As long as people do not have to worry about investing in activities that minimise their tax burden, they can engage in ventures that they believe will provide the best returns.
Vertical equality demands that rich taxpayers should pay more than people on lower incomes. The flat tax rate achieves this goal by giving a generous personal allowance that makes the system progressive. So not only are some of those on lower incomes exempt from paying any income tax, the allowance is more important to the people earning just over the allowance threshold. The real percentage that people pay increases with the amount they earn.
A common criticism leveled at a flat tax system is that it will lead to a reduction in government revenue because higher earners in society are no longer paying an increased rate of income tax. Economic theory shows, however, that you can collect the same amount of tax using a graded income tax system or a flat tax system.
The case of Estonia is instructive. Since the implementation of a flat tax system in 1994, Estonian government revenue has increased steadily thanks to increased compliance with the simplified system and to associated economic growth.
International competition demands that capital and labour move according to changes in market conditions. This principle has been applied to a new investment strategy proposed by Dr Laffer, who advises that we should invest in stocks in companies from lower tax regulation areas and sell stocks in companies in high-tax, high-regulation regions. This can be illustrated by a simple hypothetical example. Between January and August 2004, $4,000 is invested in the four lowest-tax-rate countries in Europe. We put $1,000 into Ireland, $1,000 into Latvia, Lithuania and Malta. This portfolio would have grown to $6,750 in just eight months, yielding a net gain of 69%. Over the same period, German and French benchmarks fell by 40 to 45%. While I would not argue that a flat tax is the sole contributing factor to this outcome, it is clear that it has played an important role.
I have already mentioned a reductionist trend in Eastern European tax rates. The best evidence for this is Estonia, which initially started a flat tax reform in 1994 with a 26% rate, but is now proposing to lower the rate to 20% by 2006. This is a clear example of tax competition between the nations of the region as they compete with one another for foreign investment.
Having focused on the East, I would now like to look at the West to determine how it would respond to the implementation of a flat tax.
A flat tax is simple and efficient in terms of filling out a tax form. The only calculation to be made is revenue minus personal allowance, multiplied by the flat tax rate. It takes twenty minutes and it is good for both the government and the taxpayer. It makes policing compliance easier for the government and eliminates the need for citizens to waste time searching for loopholes. Those on low incomes below the personal allowance threshold will not have to pay any tax at all, providing people with a clear incentive to work.
A second advantage of a simplified system is that it will put a stop to the current process of interest-group lobbying for tax breaks, which takes place across European capitals. Having every company and individual subject to the same principles of taxation creates a level playing field for business and thus promotes fair competition.
So far I have focused on the macro level, but a flat tax would also promote change for individuals. It sounds appealing to say that the government will not have as much power over people’s spending and assets, but people would also have to reconsider all the things that are currently deductible under the current system – charitable donations, fringe benefits, entertainment expenses, mortgage payments. In many countries, people are used to deducting their mortgage payments. Under a flat tax system, people would have to understand that the tax rate would offer them more money. But it would also impose on them more responsibility in providing for their future, their pension, their health insurance, and so forth. In this sense, it would really empower the individual.
It is obvious that the flat tax system has succeeded in Eastern Europe. Growth rates, levels of foreign investment and a decline in tax evasion are all testament to its success.
In Western Europe the attitude is somewhat more sceptical. On the left, the flat tax is opposed because it is thought to reward the rich. High earners are content with the current system because of the wealth of tax deductions that it offers them. Western European societies appear emotionally attached to their systems. Even in the United States, a flat tax would be met with some suspicion as it would prevent home-owners from deducting their mortgage payments from their liabilities.
There may, however, be a solution in the Hong Kong model. For 50 years Hong Kong has offered a dual system. People can choose between a flat tax of 16% or a graded system of 2 to 20%. One can see why people have gradually moved from the graded system to the flat tax system, because it is so much easier to comply with and carries less risk of one’s finances being investigated. I think it might be a useful starting point for Western countries to offer their citizens a choice between the two systems. I am confident that if people take up the flat tax challenge they will not choose to switch back.
© Copyright; Foundation for Economic Growth and various authors. Individual authors retain their own copyright.
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