Slovakia and the flat tax: Peer pressure

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The Czechs debate the virtues of a flat tax, but is it a fad or the future, asks Chris Mayo in Transitions Online.

The flat-tax bandwagon rolls relentlessly on. Just this year, Romania and Georgia have introduced flat taxes, forcing the poor to pay the same rate as the rich. The running total of post-communist states who have switched to a flat-tax regime is now nine, in 10 years. A tenth is all but certain to join in September when Poles go to elections in which all the major political parties are campaigning on flat-tax platforms. 

And, a year from now, all the opinion polls suggest there is a good chance that the Czech Republic will join the list of converts. The opposition Civic Democrats (ODS) have stated that they plan to introduce a flat tax of 15 percent if they triumph in next year’s election, a result that looks very probable. 

For the ODS, the shining example of the virtues of a flat tax is Slovakia, and, seduced by Slovakia’s impressive economic performance since it simplified its tax regime in 2004, it recently hosted a flat-tax forum in Prague at which the star turn was given by the Slovak finance minister, Ivan Miklos. 

Slovakia’s particular attraction for the Czechs is not simply because Slovaks and Czechs were once part of the same country. The first state to introduce flat taxes was Estonia, back in 1994. Its economic record since then has been impressive – between 1997 and 2003, Estonia’s average annual growth rate in real GDP was 6 percent – but it made its move in the early days of economic transition, days of widespread tax evasion and economic flux. The lowest flat tax introduced to date was by Russia (13 percent, in 2001, subsequently followed by Ukraine). Russia immediately harvested far fatter tax revenues – but in Slovakia, in contrast to Russia, tax collection is a relatively minor problem. Slovakia’s appeal as an example for the Czech Republic (and Poland) is that it is a country like theirs, a country with a developed economy and strong institutions – and a country that was still able to point to an immediate improvement in performance. 

Foreign investors appeared to leap to pour money into Slovakia after it introduced a uniform 19 percent rate for all personal, corporate, and sales taxes in 2004: the state investment agency signed 47 investment deals worth $2.26 billion (2.9 percent of GDP), compared to 22 deals worth $1.44 billion in 2003, prior to the introduction of the flat tax. 

But how much of this upsurge can be attributed to flat taxes? Slovakia was at the time comprehensively reforming its economy and its institutions. Did the flat tax simply tip the balance for investors who had already been attracted by the reform drive of a dynamic government? Even advocates of flat taxes agree that there was much more to the increase in FDI than a simpler tax system. “The ambitious tax reform, including the relatively low tax rate along with the abolition of taxation of dividends, has in my opinion been an important driver of some FDI,” says Marek Jakoby, an adviser to the Slovak Finance Ministry. “[But] I see it in context with other reforms including reform of labor legislation, market opportunities, developing infrastructure as well as a still advantageous ratio between labor costs and productivity.”

Others effectively attribute the entire improvement to Slovakia’s set of reforms. Grzegorz Kolodko, a former deputy prime minister in Poland and a finance minister in a Social Democrat government, argues that “if growth accelerated [after the introduction of the flat tax], as in Russia and Slovakia (and only for some time), it was so in the former due to the windfall from the high price of oil and in the latter due to other structural reforms and a sensible policy mix, including lower interest rates than in Poland.”

Particular question marks hang over the flat tax’s impact on FDI, which has for years been a particularly large contributor to the upswing in the Czech economy. Jan Mladek, a member of parliament for the Social Democrats, the largest party in the Czech parliament, dismisses the role of the flat tax in attracting investment as “complete nonsense.” 

“Multinationals are not paying corporate income tax,” says Mladek, an economic advisor to the Czech prime minister, in a reference to the extended tax holidays offered to many companies who invest in Slovakia and the Czech Republic.

Kolodko is also dismissive. Slovakia’s flat tax “is not contributing either to higher capital accumulation, or to the improvement in its efficiency. Hence, it’s not contributing to faster economic growth.” 

When Slovakia’s investment inflows are examined over a longer period, the importance of flat taxes does appear to fade. There may have been a big jump in FDI after the tax reform, but inward investment was already rising fast. Between 1995 and 2003, the accumulated total of FDI as a percentage of GDP rose from 4.2 percent to 31.5 percent, with a surge (from 18.5 percent) between 2000 and 2003. (The Czech Republic saw most of its increase – from 14.1 percent to 42.1 percent – between 1995 and 1999; by the end of 2003, the figure was 48 percent.) In other words, flat taxes may simply have helped an already accelerating trend.

It may even be that the flat tax was only a relatively minor attraction, since Slovakia’s low flat-tax regime does not mean that it is a low-tax country. Slovakia may have cut most taxes to a level unseen in Western Europe (19 percent) but its payroll taxes – payments for social security and health – are, according to the World Bank, the highest in the European Union. Some investors with relatively few employees might therefore be attracted by the flat tax, but others may have been put off by payroll costs. For most companies, payroll taxes are more significant than corporate and income taxes.

Nonetheless, the attractions of low wages in Slovakia more than compensate: in 2003, the average monthly wage across Poland, Hungary and the Czech Republic was 542 euros; Slovakia’s average monthly wage was 30 percent lower at 381 euros. With a gap as large as that and levels of political stability, productivity, infrastructure and education similar to those elsewhere in Central Europe, it is not difficult to see why Slovakia is, in relative terms, an attractive choice for foreign investment. Flat, simpler, lower taxes may have been just another, possibly relatively minor reason to invest in Slovakia. 

To read the article in full, visit the Transitions Online website.

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