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THE CASE FOR FLAT TAXES
Apr 14th 2005  

Pioneered in eastern Europe, flat tax systems seem to work because they
are simple

AN ARTFUL taxman, according to Jean-Baptiste Colbert, treasurer to
Louis XIV, so plucks the goose as to obtain the most feathers for the
least hissing. Such arts are lost in America. As the April 15th
deadline for filing tax returns falls due, the hissing is as audible as
ever. But Americans are not alone. New Zealand's tax code instils
"anger, frustration, confusion and alienation" in the islands'
businessmen, according to a 2001 report to ministers. Adam Smith spoke
for many when he bemoaned the "unnecessary trouble, vexation, and
oppression" the people suffer at the hands of the tax-gatherers.

The White House claims to be listening. Shortly after his election
victory, President George Bush set up a panel to advise him on how to
reform the tax system. A report is expected this summer. Judging by the
remit he has given them, Mr Bush wants to iron out some of the kinks in
the tax code that distort saving and deter work, while retaining tax
breaks for charity and home-ownership. But he also wants to simplify
the tax code for simplicity's sake.

The Americans are talking about it. Meanwhile in Europe, east of Vienna
and as far afield as Russia and Georgia, they are actually doing it. In
1994, Estonia became the first country in Europe to introduce a
so-called "flat tax", replacing three tax rates on personal income, and
another on corporate profits, with one uniform rate of 26%. Simplicity
itself. At the stroke of a pen, this tiny Baltic nation transformed
itself from backwater to bellwether, emulated by its neighbours and
envied by conservatives in America who long to flatten their own
country's taxes. 

Latvia and Lithuania, Estonia's Baltic neighbours, promptly followed
its example. In 2001, Russia too moved to a flat tax on personal
income. Three years later, Slovakia imposed a uniform 19% rate on
personal and corporate income, and set the same rate for its
value-added tax (VAT) too, for the sake of symmetry rather than
economic logic, it seems. In Poland, Civic Platform, a centre-right
opposition party, wants to mirror Slovakia, only at the lower rate of
15%. In all, eight countries have now followed Estonia (see table).

Might America do the same? The tax system there has been debated for
years. William Simon, America's treasury secretary under President
Richard Nixon, wanted a system that looked "like someone designed it on
purpose". But the bewildering bulk and complexity of a modern tax code
is not only the result of poor or malicious design.

Fairness is the chief reason why most countries have imposed multiple
rates of tax. In Canada, Australia and the European Union, for example,
staple foods, but not restaurant meals, are exempted from value-added
tax. This is deemed fair because the poor spend a greater share of
their income on unprepared food. It can lead to nonsense, however.
Jeffrey Owens and Stuart Hamilton of the OECD point out that hot roast
chicken is taxed, but cold roast chicken is not. "Does anyone expect
tax administrators and business owners to have thermometers on hand
when they do their tax calculations?" they ask, only half in jest. 

In Luxembourg tax collectors work with no fewer than 17 different tax
brackets, to ensure rich Luxemburghers pay a greater proportion of
their income than their slightly less rich countrymen. The
international trend, however, is away from such pointillism towards
broader brushwork. Between 2000 and 2003, the OECD reports, seven of
its members (including Luxembourg) cut the number of brackets, although
Canada, Portugal and America all added one.

Fewer brackets are simpler to administer, but one bracket is simplest
of all. Under a pure flat tax, the taxman takes the same cut from the
last dollar you earn that he took from the first. The appeal to high
earners is obvious. But the administrative elegance of such a system is
not so immediately apparent. Because every dollar is taxed at the same
rate, it does not matter to the tax collector how many dollars are
going to whom. Thus, in principle, the taxman could simply withhold 20%
of a company's payroll, without needing to know who was paid what. Add
a second rate of tax, however, or a personal exemption, and the tax
collector must find out how much money is going into each pay packet
before he can be sure of collecting the right amount from the right
person. In America, for example, the tax collector needs to tax the
wage packets of 130m or more employees, rather than simply taxing the
payrolls of 8m or so enterprises.

How much fairness is gained for all this extra complexity? Surprisingly
little, suggest Messrs Owens and Hamilton. In New Zealand, for example,
only the richest tenth of households pay much more under the country's
progressive income tax than they would under a 25% flat tax (see
chart). Most of the redistribution in New Zealand is carried out on the
other side of the government's ledger, by spending more money on poor
people. 

To the layman, a flat tax simply means a single rate of income tax. But
the connoisseur of the flat tax can distinguish several different
varieties. In America the flat tax is associated with a proposal
advanced by Robert Hall and Alvin Rabushka, two economists at the
Hoover Institution. Their tax, which falls on businesses and
households, and allows a personal exemption, is designed not to tax
saving. It thus resembles a consumption tax, such as VAT, more than a
traditional income tax, which is typically also levied on returns to
saving, such as interest and dividends. Slovakia, which taxes profits
firms make, but not the dividends they distribute, perhaps comes
closest to this model.

FLAT, NOT LOW
Nor are flat taxes synonymous with low taxes. Certainly, most countries
have cut their tax rates as they have flattened them. In 1994,
Ukraine's top rate reached the stratospheric level of 90%, before
descending, in stages, to its current single rate of 13%. But
Lithuania's 33% flat rate is too high for some American conservatives.

Nevertheless, Lithuania's example might make flat taxes more palatable
to the social democrats of western Europe. Miguel Sebastian, an
economic advisor to Spain's socialist government, has advocated
(largely in vain to date) a flat tax of 30% on Spanish incomes. Last
year, a panel of academics set up by Germany's finance ministry also
proposed a 30% flat tax on all personal and corporate income.

Flat taxes differ in scope as well as height. Since 2001, Russia has
imposed a single 13% tax rate on all personal income. But it has a
different rate for corporate profits: 35% at the time of its 2001
reform. Slovakia's flat tax, by contrast, covers both personal income
and corporate income, as well as VAT. Taxing pay packets and profits at
the same rate discourages an obvious form of "tax arbitrage". For
example, it was reportedly quite common for Slovak salarymen to declare
themselves self-employed, while continuing to work for the same company
much as before. Their wages would then be taxed as profits. Not only
that, their lunch could be counted as a business expense.

Unfortunately, Slovakia's fiscal purism is somewhat adulterated by a
heavy payroll tax. The social-security contributions of employees and
employers combined amounted to almost half of labour income in 2004.
Since this burden falls on earnings from work, not from capital, it
restores the incentive for Slovaks to convert one into the other, by
declaring themselves self-employed subcontractors. It may also drive
some economic activity into the shadows, where the social-security
agency cannot find it.

 At the time of its reform, Estonia also taxed labour and capital at
the same rate. After 2000, however, it chose not to tax profits at all
until they are distributed to shareholders as dividends. This gives
companies an incentive to retain their earnings and reinvest them.
Indeed, very little of the burden of taxation in Estonia falls on
corporations directly: corporate taxes accounted for only 3.6% of total
tax revenues in 2003.

Estonia's economy has grown impressively since its 1994 reform. Growth
reached double digits in 1997, and has since settled at around 6%
annually, after a slump at the turn of the century. Repealing its high
tax rate on the rich did not erode the country's tax base as some might
have feared. In 1993, general government revenues were 39.4% of GDP; in
2002, they were 39.6%. Estonia now plans to cut its flat tax from 26%
to 20% by 2007. 

But how much do Estonia's robust revenues owe to its flat income tax?
Perhaps less than is frequently advertised. In 1993, the year before
its reform, Estonia's multiple personal income taxes raised revenues
amounting to 8.2% of GDP. In 2002, its flat income tax raised revenues
worth just 7.2%. Indeed, the flat income tax that generated so much
excitement abroad seems to be carrying less weight than Estonia's
old-fashioned VAT, which raised 9.4% of GDP in revenues in 2002. 

VAT is, of course, the flattest tax of all. It levies a uniform rate on
the goods you buy, taking a constant cut of your money when it is spent
as opposed to when it is earned. Estonia's VAT is also quite broad,
leaving relatively few things out (hydropower and windpower were two
curious exceptions). The same point could be made about Slovakia. At
19%, it has a relatively low rate of income and corporate taxes, but
one of the highest rates of VAT in Europe. It may be this high rate of
VAT, not the flattening of its other taxes, that sustains the
government's revenues in the future.

FLAT TAXES ON THE STEPPES
The most remarkable turnaround in government revenues was recorded in
Russia. Prior to its 2001 tax overhaul, the federal government's
tax-raising powers were rapidly deserting it. Clifford Gaddy and
William Gale of the Brookings Institution report that tax arrears
amounted to 34% of collections in 1997. By 1998, federal revenues had
fallen to just 12.4% of GDP, leaving the government unable to pay its
creditors. Investigators appointed by the president revealed that
Russia's biggest enterprises ignored 29% of their taxes and paid
another 63% in kind, with goods and services the government might or
might not want. In lieu of $80,000 in taxes, one company reportedly
offered the government ten tonnes of toxic chemicals. 

On January 1st 2001, Russia flattened and broadened its personal income
taxes, collapsing 12%, 20% and 30% bands into a single, uniform 13%
rate. The state also withheld taxes at source, identified taxpayers by
number, and audited suspected tax-dodgers. Messrs Gaddy and Gale note
that no tax system could hope to bring in much revenue without these
rudimentary instruments of tax enforcement. 

How did revenues respond? A year after the reform, the personal income
tax was raising almost 26% more revenue in real terms. Some of this was
due to the rebound in the economy: real wages grew by 12% that year,
and the take from all taxes, flat or otherwise, consequently improved.
But the surge of rubles encouraged by the flat tax was more sustained.

A careful study by two IMF economists, Anna Ivanova and Michael Keen,
together with Alexander Klemm, of the Institute of Fiscal Studies in
London, tries to unearth the causes of this pleasant fiscal surprise.
They find little evidence that Russians, freed from the yoke of
progressive taxation, suddenly started working much harder. This is
perhaps not surprising, as Russia's reform actually raised personal
income taxes for the many households that previously fell into the 12%
bracket.

They did discover a conspicuous increase in compliance with the tax
authorities, however. In the year before the flat tax, Russians in the
two higher tax brackets reported only 52% of their income to the
taxman. In 2001, after falling into the new, all-encompassing 13%
bracket, these same households reported 68%.

Many advocates of the flat tax, particularly in America, argue that it
sharpens the incentive to work. A progressive income tax, they claim,
deters extra effort from society's best-paid (and therefore most
productive) members. Russia's experience, however, suggests that the
principal virtue of the flat tax is its simplicity. The government's
revenues did not surge because Russians suddenly squared their
shoulders and straightened their backs. Rather, Russia's tax system
became easier to administer and easier to comply with.

America is not Russia. It has a functioning tax system, albeit a clumsy
one, so has something to lose from uprooting its tax system and
starting again. But the potential gains are not negligible. In a
typical year, the IRS estimates that for every dollar it collects,
another 19 or 20 cents is owed, but not paid. This shortfall amounted
to between $312 billion and $353 billion in 2001. Small businesses fail
to report about 30% of their earnings. Babysitters and gardeners fail
to report 80%, says the IRS.

In part, the tax system is burdensome because people dodge it. Every
loophole that is exploited must be plugged. Every blurry line that is
crossed must be sharpened. But Messrs Owens and Hamilton worry that the
tax-codifiers and the tax-dodgers are locked in a mutually destructive
"arms race". The code is made more complex, because of tax wheezes.
More people then seek to avoid taxes. The best way to fight tax
avoidance, then, is with simplicity. 

As every American knows, their country was founded in the wake of a tax
revolt. What most forget is that the so-called "Boston tea party", a
raid on the cargo of British ships in Boston harbour, was not provoked
by a tax hike. The British had in fact scrapped duties on tea, cutting
out commercial middlemen. It is not going too far, then, to suggest
that the American Revolution was provoked by a simplifying tax reform.
Mr Bush must hope his own reforms, should they ever see the light of
day, will encounter less stiff resistance.

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