Tuesday, December 05, 2006

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.


Anonymous said...

I thought you'd get round to this.

Problem - East Europeans do NOT have flat tax systems. TO call these "flat tax" is an insult to flat tax.

Nominal income and corporation tax are quite low, but social security contributions are very high (up to 50% of wages), so official unemployment is very high (better to work cash in hand and avoid the social security).

If they did have proper flat tax systems where everybody pays the same rate (whether benefit claimant, employee, small business or multinational) with no EXTRA tax on employment income, then yes, the headline rate would be higher, 30%-ish, but things would look a lot rosier all round.

wozza said...

the way low GDP countries get away with a flat tax is that they no the richest hundred or so will never pay the tax they should - and it's best to get a little from all the poorest and middle class.

In countries where the wage disparity between even the middle and the bottom is as wide as it is here the flat tax (unless also replacing VAT, and even then) would still be far too deeply regressive.


Anonymous said...

Wozza, that is quite simply not true, it depends on how you set the personal allowance and the rate. e.g. a personal allowance of £9,ooo and a rate of 30% (incl. National Insurance) would mean that all lower and middle earners are much better off.

wozza said...

i will allow a former Thatcher policy adviser to explain my concerns in detail:

Brian Reading, "Flat Tax: An Idea Whose Time Has Gone", in Lombard Street Research Monthly Economic Review, September/October 2005.

nine losers for every winner

Roger Bootle in the Torygraph says many people who previously paid nothing will be brought into it.

wozza said...

and an IMF study calls the Flat TAx as used in Eatern Europe a fad that may have to be remade.


Anonymous said...

Wozza, yes I have read all these reports, but it depends how you defined flat tax.

I see it as meaning that everybody pays the same rate - employees should pay a lot less, companies should pay a bit more, all reliefs and exemptions that primarily benefit higher earners can be scrapped. Such a fiscally neutral rate would be 30% plus, with of course a much higher personal allowance to ensure that benefit claimants have a total marginal tax/benefits withdrawal rate no higher than 30% plus.

The East European systems are the antithesis of flat tax because employment income is taxed two or three times as heavily as corporate income.