Flat tax: Economic panacea or pandora?

‘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

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.”

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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