CIAO DATE: 06/06

European Affairs

Fall 2005

 

Finance and Banking

Will Europe's Flat Tax Revolution Spread from East to West

By Daniel J. Mitchell

 

For years during the Cold War, the capitalist countries of the West benefited from far more dynamic economic systems than their Eastern rivals. Today, however, the former communist countries are making a determined bid to turn the tables. Nine nations from the old Soviet Bloc have adopted simple and fair flat tax regimes, and others are poised to follow suit. These countries are rejecting the European social model of progressive taxes and implementing a system based on the notion that all citizens should be treated equally.

Four of the flat-tax countries – the three Baltic states and Slovakia – are members of the European Union, and a fifth, Romania, is due to join in 2007. The success of their new low-tax systems in attracting investment and stimulating economic growth is putting increasing pressure on their high-tax Western European partners to consider tax reforms that might ultimately lead in a similar direction – despite strong political opposition in many countries.

Under a flat tax, all households receive a generous family-based allowance, and are then taxed at a low rate on any income above that amount. Graduated tax rates are abolished and all loopholes are eliminated. This type of tax reform simultaneously creates a simple and transparent tax system and minimizes tax penalties on work, saving and investment. Free-market Estonia was the first to adopt a flat tax, implementing a 26 percent rate in 1994, not long after the collapse of the Soviet Union. The two other Baltic states followed in the mid-1990s, with Latvia choosing a 25 percent rate and Lithuania 33 percent. Learning from its neighbors, Russia shocked the world with a 13 percent flat tax that went into effect in 2001. The idea was taken up in 2003 by Serbia, which adopted a 14 percent rate. Slovakia climbed on the bandwagon the following year with a 19 percent rate, as did Ukraine, which chose 13 percent. Romania joined the flat tax revolution in 2005, with a 16 percent rate, along with Georgia, which chose 12 percent – giving it the honor (at least so far) of having the lowest rate.

The flat tax revolution has been so successful that Estonia is lowering its rate to keep pace with other nations. The Estonian flat tax is now down to 24 percent and is supposed to fall to 20 percent by 2007. Lithuania is also planning to drop its rate to 24 percent in response to competitive pressure. But this may be just the tip of the iceberg. Lawmakers in Croatia, Bulgaria, and Hungary are discussing the flat tax. Opposition parties in the Czech Republic have promised to implement a 15 percent flat tax if they win the next election. Hopes for a flat tax in Poland, however, suffered a setback in October when the ostensibly right-wing Law and Justice Party chose to form a government without including the pro-flat tax Civic Platform parliamentary group.

“Public finance experts see the flat tax as especially beneficial for developing and transition economies”

Despite such widespread enthusiasm, it is legitimate to ask whether the flat tax revolution is a good thing – particularly as it has not so far spread to any Western European countries.

An idea is not necessarily good just because it is being widely adopted. After all, numerous countries nationalized industries after World War II, only to discover that government-owned companies misallocated resources and placed heavy burdens on taxpayers. The trendy flat tax has wide support among public finance experts, who see it as especially beneficial for developing and transition economies that need faster growth and better tax compliance. The flat tax embodies the following principles:

• Tax income at the lowest possible rate to encourage pro-growth behavior: The marginal tax rate is a price that government imposes on productive economic behavior. Low-rate flat tax systems impose the lowest possible penalty on work, risk-taking and entrepreneurship. Central and Eastern European nations certainly understand this principle. Flat taxes in the region already average less than 19 percent and are coming down every year.

• Tax income only once, so there is no bias against saving and investment: A key feature of a pure flat tax is a “consumption base,” eliminating tax bias against income that is saved and invested. This means no death tax, no capital gains tax, no double-tax on dividend income and no second layer of tax on saving. Not all the Central and Eastern European flat taxes have fulfilled all these criteria, but double-taxation of capital has been substantially reduced.

• Eliminate back-door industrial policy by removing preferences: Special tax treatment distorts the allocation of resources and thereby undermines economic growth (and encourages corruption). The flat tax seeks to eliminate or minimize the impact of the tax code on decision-making by treating all income equally, regardless of how it is earned or spent. Central and Eastern European nations, especially Slovakia and Estonia, have dramatically reduced tax breaks.

Other important advantages of the flat tax include simplicity and territoriality. It should be noted, however, that Central and Eastern European nations do not have perfect tax systems. None of them has adopted the pure version of the flat tax first proposed by Professors Robert Hall and Alvin Rabushka at Stanford University, and many of the flat-tax countries are still plagued by extremely high payroll taxes.

But these flaws notwithstanding, empirical evidence already shows that tax reform is having a desirable impact. The Baltic nations, for instance, are the most prosperous of those that emerged from the former Soviet Union. Estonia, Lithuania, and Latvia are now known as the “Baltic Tigers” and all three easily met the economic criteria to become members of the European Union, which they joined in May 2004.

The Russian Federation, which followed the Baltic States in adopting a flat tax, is the next most prosperous of the former Soviet Republics. The evidence from Russia, where the 13 percent flat tax has helped produce an economic boom, is particularly striking. Russia's economy has expanded by about seven to eight percent annually since 2001, a rather noteworthy track record considering the tepid performance of most European nations. The Russian economy has even performed better than the U.S. economy – although it is fair to note that high oil prices have also played a key role.

In addition to faster growth, Russia's tax reform has dramatically improved tax compliance. Over the past four years, inflation-adjusted income tax revenue in Russia has grown by more than 100 percent, demonstrating that people are willing to produce more and pay their taxes when the system is fair and tax rates are low.

Slovakia is another success story. Its 19 percent flat tax has attracted worldwide attention, and Slovakia now has more foreign direct investment per capita than any other nation. So many auto companies are building factories there that Slovakia is now known as the “Detroit of Europe.” Even nations that only recently adopted the flat tax – such as Romania in January 2005 – are creating more jobs and collecting higher tax revenues.

The economic performance of flat tax countries should not come as a surprise. After all, Hong Kong, which introduced a flat tax in 1947, has been among the world's fastest growing economies ever since. Much less well known is the experience of the Channel Islands, the small British territories off the Normandy coast of France, which have become very wealthy in part because of their low-rate flat tax systems.

“The Baltic nations are the most prosperous of those that emerged from the former Soviet Union”

Tax competition comes into play when politicians feel compelled to lower taxes for fear that jobs and capital will migrate to nations with more attractive tax systems. This process has certainly played a role in Central and Eastern Europe's flat tax revolution. In some cases, tax reform is implemented because policy makers want to mimic success in other nations. But in many cases, governments enact the flat tax because they fear that productive resources will leave for destinations where taxes are lower. In other words, the geese that lay the golden eggs may fly away.

This is why the flat tax is causing anxiety in Western Europe. Leftist politicians complain about “harmful” tax competition because it is increasingly difficult to maintain a welfare state when those that pay the bills have the option of fleeing to more hospitable climes.

Acting at the behest of nations such as France, Germany and Sweden, international bureaucracies such as the European Commission and the Organization for Economic Cooperation and Development have launched major campaigns to thwart tax competition. The Commission has primarily focused on EU member nations (although the recently implemented savings tax directive was contingent on Swiss participation and originally was predicated on U.S. support), while the OECD primarily has targeted nations in the developing world.

“It will be a long struggle before any of the Western EU member states adopts the flat tax”

The Commission has had some success. All EU member states have to apply Value Added Tax (VAT) rates of at least 15 percent. And the savings tax directive is a first-step effort to impose minimum tax rates on saving, even if the income has already been taxed when first earned. But the Commission has also failed in several areas. It has been pushing to harmonize corporate tax rates for nearly 20 years with no success. It now is working to harmonize the corporate tax base (the definition of taxable income), but already has acknowledged that it will be unable to impose a common system throughout the European Union.

The obstacle – at least from the perspective of high-tax nations – is that EU decisions on tax policy must be unanimous, allowing individual nations to veto plans for EU-wide taxes. Lower-tax nations like Britain, Ireland, Slovakia, and Estonia have thus been able to block the high-tax countries, such as France and Germany, from pursuing a tax harmonization agenda. The right of veto on taxation was maintained in the projected new EU constitutional treaty, after British Prime Minister Tony Blair and others led a hard-fought battle to keep it.

Although the treaty is currently in abeyance, following its rejection in French and Dutch referendums in the summer of 2005, the maintenance of the veto was an important pointer to the future of EU tax policy. The admittance of ten new EU members, mainly in Central and Eastern Europe, in 2004, has further complicated the tax harmonization agenda. Having endured decades of communism, leaders in Eastern Europe are unlikely to sacrifice growth just to appease politicians in the West.

Some Western European lawmakers see the handwriting on the wall and have begun to talk about the possibility of a flat tax in their own countries. While there is certainly not yet a political consensus for reform, Spain, Denmark, The Netherlands, Germany and the United Kingdom are among the nations where the flat tax is being examined. The fact that these discussions are even taking place is testimony to the force of tax competition.

It will be a long struggle, however, before any of the 15 older, Western EU member states adopts the flat tax. A rumor that the Greek government would announce a flat tax in September turned out to be a false alarm. The German election resulted in an even bigger setback, since the Christian Democrats, who won by an extremely narrow majority, allowed the flat tax to become an issue in the campaign but were not prepared to defend it. Fumbles by the Christian Democratic leadership allowed the Social Democrats to portray the flat tax as a scary prospect to German voters. Nonetheless, it may just be a matter of time before the “tax curtain” is breached and the flat tax spreads to the West. One potential catalyst is China. If current speculation that China may implement a flat tax in 2006 is correct, it could be the spark that lights the fuse for a new wave of international flat tax reform.

It is important to bear in mind, however, that a flat tax is not a cure-all for Central and Eastern Europe, and would not solve all of Western Europe's problems either. The older EU member states would probably not grow quite as fast as Estonia or Slovakia if they adopted a flat tax because they are starting from a higher level of economic development. Nor is it likely that their governments would get the same revenue windfall as Russia if they enacted a flat tax since their underground economies are not as large.

But theory and evidence suggest that tax reform in the main body of the European Union would mean stronger growth, as it has in Central and Eastern Europe. There are good reasons to believe that a flat tax would also improve tax compliance in the West, in the same way that it has reduced evasion and avoidance in the East. A flat tax in Western Europe could also reduce political corruption, just as it has curtailed interest-group pleading in Eastern Europe.

Both inside the European Union and beyond, Central and Eastern Europe's flat tax revolution is serving as a role model for developing and transition economies. The flat tax demonstrates that it is possible to grow faster and create a more transparent tax code. The most important lesson, however, is that the European social model is not monolithic. Graduated tax rates are not an inevitable feature of modern tax systems. The continuing pressures of tax competition may soon make systems based on the Marxist doctrine of “from each according to ability” relics of the past.

Daniel J. Mitchell is a McKenna Senior Fellow in Political Economy at The Heritage Foundation and the chief expert on tax policy and the economy. He advocates supply-side tax policy and fundamental tax reform. Previously, he was as an economist for Republican Senator Bob Packwood of Oregon and the Senate Finance Committee. He also served on the 1988 Bush/Quayle transition team and was Director of Tax and Budget Policy for Citizens for a Sound Economy.