Flat taxes and Flat Earth Society?

By bne IntelliNews November 1, 2006

Nicholas Watson in Prague -

Macedonia is set to become the 10th country to introduce a flat tax in the CEE region. The IMF asks: are flat taxes all they're cracked up to be?

Like clothes and music, policies go in and out of fashion. The latest craze in the world of economics is the flat tax – a tax regime that has so far been introduced into nine countries in Central and Eastern Europe, with the 10th country set to be Macedonia.

On October 19, Macedonia's Ministry of Finance announced it plans to introduce a flat income and corporate tax of 12% in 2007, which would then be lowered to 10% by 2008. The new flat tax would replace the current corporate tax of 15% and a progressive personal income tax that ranges from 15% to 24%. The government also plans to scrap the tax on reinvested profits altogether.

"This step should decrease tax evasion and stimulate taxpayers to meet their obligations to the state. It would also encourage foreign investors to put their money in Macedonian businesses, knowing that taxes are low," the ministry said in a statement.

This poor Balkan country needs all the tax receipts and the investment it can get. According to the World Investment Report 2006 published by the United Nations Conference on Trade and Development, foreign direct investment (FDI) in Macedonia last year was almost half that of 2004, ranking the country at the bottom of the FDI table in the region. Roughly $100m was invested in Macedonia in 2005 compared with $157m the year before.

Increased compliance and foreign investment are two of the most obvious benefits of the flat tax system, which was first introduced in Estonia in 1994, say proponents. The two other Baltic states, Latvia and Lithuania, swiftly followed Estonia's lead in the mid-1990s. Since the beginning of the decade, Russia, Serbia, Ukraine, Slovakia, Georgia and Romania have all introduced flat tax regimes.

And the system is supposed to be simple and cheap to administer; the most rightwing advocates claim it even encourages people to work harder as employees are not penalised for earning more money.

These are persuasive arguments for the flat tax, but given the relatively short history of this so-called "tax revolution," until now the debate has been, "marked more by rhetoric and assertion than by analysis and evidence," a new paper from the International Monetary Fund (IMF) claims.

The paper, entitled "Flat Tax: Principles and Evidence" and written by Mick Keen, Kevin Kim and Ricardo Varsano, makes unhappy reading for the flat tax evangelists.

"Looking forward, the question is not so much whether more countries will adopt a flat tax as whether those that have will move away from it," the authors conclude.

Falling flat

The report sets about trying to establish whether the flat tax system does what it says on the tin: namely, the loss of tax revenue from introducing the flat tax is offset by rising output; tax avoidance falls; the incentives to work increase; there is a reduction in the progressiveness of taxes; the tax code becomes significantly simpler; and it deals with the problems of how to tax internationally mobile capital income.

While acknowledging that the flat tax systems adopted over the past decade or so have differed widely, the report nevertheless claims that a few key lessons emerge.

The first is that there is little evidence of the so-called Lather effect, named after an ardent Reaganite Arthur Laffer, who reckoned that the effect of cutting taxes is rising output and falling tax avoidance that offset the loss of tax revenue.

"In no case does there has appear to have been a Laffer effect: these reforms have not set off effects strong enough for them to pay for themselves," the report says.

What about compliance? Much has been made by advocates of flat taxes about the incredible turnaround in Russian government revenues after it flattened its personal income taxes into a single 13% rate from the previous 12%, 20% and 30% bands. By 1998, federal revenues had fallen to just 12.4% of gross domestic product (GDP), but a year after the reform the personal income tax was raising almost 26% more revenue in real terms.

The authors acknowledge there is evidence that compliance improved after the reform, but then go on to say there is no firm evidence that, "it was due to the tax reform rather than to changes in enforcement occurring around the same time."

The simplification argument is also, well, an over-simplification apparently. Flattening the tax rate is certainly a simplification, the report notes, but the complexity of taxation comes mostly from the exemptions and special treatment of various kinds, which must be eliminated too but often are not. Thus the evidence from Russia, "does not suggest that the system was widely seen as significantly less complex after adoption of the flat tax," it says.

Richard Murphy, founder of the Tax Justice Network and director of Tax Research LLP, backs the IMF report and argues it is nonsense that a flat tax means simpler administration of the tax system. "Flat tax does not ease the admin burden of tax – 84% of people in Estonia have to submit tax returns, only 16% do in the UK," he says.

Finally, the authors conclude that the rapid economic development undergone by these countries, the principal reason why such flat tax systems were introduced in the first place, may ironically actually portend the end of these tax systems. The report says flat taxes were adopted by new, democratic governments desperate to signal to the global investment community that there had been a fundamental shift towards more market-oriented policies.

"In several cases, the signal appears to have been well-received," the report says. "Where no such reputation needs to be acquired, the appeal of the flat tax is consequently less."

Send comments to Nicholas Watson

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