Doubts grow about Eastern Europe's Flat Tax model

From Businessweek:

Doubts over the flat tax are being voiced not just by voters but also by economists, drawn to the subject because of its current vogue, who have found that it does not have all the benefits that its proponents claim.

An International Monetary Fund (IMF) working paper published in September argued that previous debate over the tax "had been marked more by rhetoric and assertion than by analysis and evidence."

Supporters of the flat tax often deliberately confuse the impact of moving to a flat system with the impact of cutting tax rates or simplifying the system. Often the switch to a flat system involves cutting and simplifying, but these are separate issues from the tax rate.

Looking at the impact of moves to a flat system in the region, the IMF economists found that this did not increase revenues unless the tax was set at a high level, such as in Lithuania and Latvia.

Behavioral effects such as improved incentives were usually not enough to compensate for a cut in overall tax rates, contradicting the hypothesis by the economist Arthur Laffer that revenues would increase as rates were cut. "Behavioral responses may have mitigated the revenue loss, but in no case does there appear to have been a Laffer effect," the researchers found.

The IMF examined the only significant exception, Russia, but found that improved tax collection there was more a consequence of fast economic growth and improved enforcement than of the move to a flat system in 2001.

The impact of the flat tax on incentives is in any case ambiguous. Cutting marginal tax rates will increase incentives, especially for those at the lower and upper ends of the income scale. However, some taxpayers may be less motivated to work harder if average tax rates fall because they will more easily achieve the standard of living they aspire to. Many others, of course, are salary earners and cannot work harder in any case, regardless of whatever tax incentives are offered. Extra revenue from incentives offered to entrepreneurs is likely therefore to fail to match the reduced revenue from the majority of taxpayers if overall rates are cut.

In conclusion, the IMF paper argues that flat taxes may not be suitable where the fairness of the tax authorities is less in doubt, where there is no need to signal a shift to a market economy, where tax compliance is better established and tax administration more effective, where income tax is more important in revenue terms, and where the presumption of the progressivity of marginal rates is more entrenched.

This would imply that rather than Western Europe coming to embrace the flat tax mantra, it is Central and Eastern European states that will adopt a progressive system as their economies develop.

This is even more likely given the pressure that the new EU member states will come under to close their budget deficits. Flat taxes can only work politically if they are set at a low level. However, government spending in this region is still very high. To finance this and at the same time meet the budget-deficit convergence criteria to adopt the euro, Central Europe would have to set flat taxes at a rate that would harm the middle class and constitute electoral suicide.