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Flat tax: Economic panacea or pandora?

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Published 21 January 2005 - Updated 29 January 2010
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'Flat tax' is all the talk in the new member states these days, and calls for tax cuts and simplification are also coming from elsewhere in Europe. Meanwhile, divisions remain on its merits.

Although ‘flat tax’ is not touted as a panacea to all economic ills, an increasing number of European countries – among them a few new EU member states – have introduced or are developing one-size-fits-all tax regimes. Most of these countries are confronted with sizeable budget deficits, and several face the need to align their economic status with the eurozone's requirements.

Flat tax is believed to: 

  • help reduce red tape and associated difficulties and confusion
  • reduce inequity (same rate for all) 
  • counterbalance tax dodging and cheating
  • provide incentives to work, save and invest 
  • generate increased tax revenue, and thus 
  • spark off a 'mini economic boom'

At the same time, a flat tax regime is understood to

  • eliminate practically all forms of tax exemptions and allowances
  • be non-progressive (at least as far as the 'marginal' rates are concerned)
  • favour the wealthy at the expense of the poor
  • favour share and dividend-holders since profits are taxed only once, at source (ie 'flat tax' is a consumption-based tax)

Whether the seemingly popular switch over to a flat tax system is driven by sound fiscal policy strategies or rather by a desire to somehow make the citizens pay more into the state’s coffers is a moot point. One key conclusion cited by several researchers is that the efficiency and success of a flat rate regime is inherently dependent on the actual level of the tax rate: the lower it is, the more efficient it tends to become.

Experts also call attention to the fact that a country’s competitiveness is determined by a number of other factors besides its tax system or the type of support the country gives to new investments. While it is generally true that lower taxes leave more money to circulate – and thus to be invested – in an economy, and that flat rates generally increase the citizens’ willingness to pay their taxes, lower taxes may also mean lower tax revenues, which in turn may be detrimental to the given state’s budgetary status. 

Furthermore, some leaders of Europe’s stronger economies, among them German Chancellor Gerhard Schröder and Sweden’s Prime Minister Goran Persson have said that the Eastern 'transition' economies can afford to cut taxes not least because any lost revenue is more than compensated by hefty subsidies from the EU. This argument has repeatedly been refuted by those 'transition' states affected. Meanwhile, Germany, as well as Italy, Austria, Finland, Denmark and Greece have also decided to introduce tax cuts in various forms and brackets in order to boost investment and spending and spur growth. 

During the past two years, the changes were as follows:

Top income tax and corporate tax rates in the EU-25 and the four candidate states (source: Heritage Foundation and national reports):

Income tax Corporate tax
2004 - 2005 2004 - 2005
Austria 50 - 50 34 - 34
Belgium 50 - 50 33 - 34
Bulgaria 29 - 29 15 - 19.5
Croatia 35 - 45 20 - 20
Czech Republic 32 - 32 31 - 28
Cyprus 30 - 30 15 - 15
Denmark 59 - 26.5 30 - 30
Estonia 26 - 26 0 - 0  (on reinvested profits)
Finland 36 - 35.5 29 - 29
France 49.6 - 49.6 34.3 - 34.3
Germany 48.5 - 47 27.9 - 26.4
Greece 40 - 40 35 - 35
Hungary 40 - 38 18 - 16
Ireland 42 - 42  12.5 - 12.5
Italy 45 - 45.6 34 - 34
Latvia 25 - 25 19 - 15
Lithuania 33 - 33 15 - 15
Luxembourg 38.95 - 38.95 30.38 - 22.9
Malta 35 - 35 35 - 35
Netherlands 52 - 52 34.5 - 34.5
Poland 40 - 40 27 - 19
Portugal 40 - 40 30 - 30
Romania 40 - 40 25 - 25
Slovakia 38 - 19 25 - 19
Slovenia 50 - 50 25 - 25
Spain 48 - 45 35 - 40
Sweden 60 - 60 28 - 28
Turkey 40 - 40 33 - 30
United Kingdom 40 - 40 30 - 30
Positions: 

The Commission believes that there is no need for an across-the-board harmonisation of the member states' tax systems. Provided that they respect Community rules, member states are free to choose the tax systems that they consider most appropriate and according to their preferences. Meanwhile, the EU continues its fight against what it considers harmful tax competition. 

"Income tax is not only complex, it is perverse, diverting energy and resources into uneconomic behaviour forced upon people by the tax code itself," argues economist Andrei Grecu of the Adam Smith Institute. "In terms of growth foregone and effort misplace, its economic costs reach into billions of pounds each year, maybe tens of billions." Flat tax is “an idea whose time has come and there will be enormous advantages for the party that embraces it”, argues the institute's president, Madsen Pirie.

Proposals for a flat rate of income and corporate tax would increase investment in Europe's largest economy, said German government adviser Wolfgang Wiegard, a member of the panel that drew up a plan for the German Finance Ministry. Under the plan, Germany should introduce a flat tax of 30% on all personal and corporate income. "Most elder members of the panel favor the flat tax," Wiegard said. "It's the younger economists who prefer the dual income tax.''

However, German economist Alexander Klemm has told BBC News that according to analyses conducted in Russia following the introduction of the flat-rate income tax in 2001, “overall the tax reform was certainly not paying for itself, in the sense that cutting tax rates has not led to higher tax revenues”. 

Poland is planning to table proposals for a flat tax in early 2007, not in 2006 as previously signaled, said Zbigniew Chlebowski, deputy leader of the Civic Platform (PO) parliamentary group, which is widely expected to win the next general elections in June 2005. The move will be part of tighter fiscal policy measures, he said.

According to former Hungarian Prime Minister Viktor Orbán, leader of the main conservative opposition party FIDESZ-MPP, Budapest will have “no choice” but to jump on the “flat tax bandwagon” in order to maintain the country’s competitiveness and retain a fair share of foreign investments. 

Czech Prime Minister Stanislav Gross is also in favour of a simplified tax system. However, while announcing that his country's growth rate is twice as high as that of the eurozone average, he also said that Prague will not introduce a flat tax rate.

"In the run-up to accession, the EU asked the newcomers from Central and Eastern Europe to phase out all discriminatory tax incentives, in particular those for foreign investors," writes Katinka Barysch of the Centre for European Reform. "To keep their economies attractive, many of the new members have responded by cutting overall tax rates for both domestic and foreign investors. Since these cuts are not discriminatory, there is nothing the EU can ­or should ­do about them. So why are some old EU members so upset about East European taxes? Perhaps some governments want to divert attention from the pressing need to clean up their own tax systems".

"Economists can debate the theory endlessly. Everyone has neat curves showing government revenue rising as taxes fall, and vice versa. Yet this debate doesn’t have to be conducted in charts, or tested only in lecture halls," writes Matthew Lynn, a columnist for Bloomberg. “Flat taxes have been introduced in several former communist countries in the past few years. So far, the evidence shows they are working.”

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Background: 

Simply put, ‘flat tax’ means that everyone is taxed at just one rate. In such a system, in place of a complex set of income tax brackets, the state declares a threshold above which all parties pay a fixed rate on all their income. This threshold is normally low enough to provide an “incentive” for the citizens to prefer paying to dodging their taxes. Such a system taxes all income once and once only, on its inception. As regards corporate taxes, the idea is similar: one bracket should fit all. 

Analysts are inclined to point out that while in the first half of the 19th century the flat tax rate was the norm in the industrialising states, the first loud calls for a “heavy progressive or graduated income tax” came from Karl Marx in his 1848 Communist Manifesto. Eventually, however, it was the capitalist part of the world that adopted Marx’s call.

Since then, the idea has been resurrected a number of times, with quite a number of countries adopting one version or another of the ‘flat tax regime’. And yet, for all the recurring debates, to date no "major" Western economy has switched over (or back) to a flat-rate income tax regime. 

According to popular belief, taxpayers all over the world take some eight billion man-hours each year to fill out their tax returns.

The modern-day renaissance of the flat-rate income tax was initiated by Estonia in 1991, followed by Latvia (1994), Lithuania (1994), Russia (2001), Serbia (2003), Ukraine (2003), Slovakia (2003), Georgia (2004) and Romania (2005). Hungary is reportedly considering introducing a version of the flat tax regime soon. 

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