Global Economics

The World is Getting Flatter


Central and Eastern European countries are looking for alternatives to progressive taxation. Would a flat tax fit the bill?

Karl Marx might be shocked to see who's doing what with tax systems in Central and Eastern Europe these days.

After all, it's the capitalist West that won't abandon progressive tax systems, which Marx championed in The Communist Manifesto, while the former Soviet bloc countries are lining up to buck their old ideological fountainhead by moving to a more regressive structure: a single tax rate for nearly all earners, regardless of income.

Nowhere has this flat tax caught on more swiftly than in Central and Eastern Europe, where nine of world's 13 countries to have adopted the system are located. It's a reform movement that started in 1994 with Estonia, gained momentum when Russia saw a 25-percent increase in state revenue from personal income tax after implementing a 13-percent flat tax in 2001, and culminated with Slovakia's much-lauded adoption of a single 19-percent rate on income, corporate, and valued added tax three years later.

Three economists with the International Monetary Fund, Michael Keen, Yitae Kim, and Ricardo Varsano, called the trend "not quite a revolution, but certainly something of a craze" in a 2006 report. And it's not slowing down. The Czech Republic's pro-business governing party, the Civic Democrats, wants to introduce a 15-percent flat income tax next year and a 19-percent corporate rate by 2010. Albania plans to halve its income and corporate taxes to 10 percent in 2008.

GUARDED OPTIMISM

But Marx may yet have the last word.

For despite claims by some that the flat tax is a simple, transparent system that spurs economies, attracts investors, and increases revenue by discouraging evasion -- with Slovakia's sustained GDP growth above 5 percent and its surging foreign direct investment as Exhibit A -- the flat tax might be getting more credit than it deserves.

As Keen and his colleagues put it in their IMF report, "Discussion of these quite radical reforms has been marked … more by assertion and rhetoric than by analysis and evidence."

Other economists are equally skeptical about the unchecked praise.

"To me, flat tax is a tax system like any other: It has its advantages and its disadvantages. It's not a magic wand you wave around and miracles happen," said Tomas Sedlacek, chief economic strategist at Ceskoslovenska obchodni banka, one of the Czech Republic's largest banks. "Flat tax can mean anything. The devil is in the details."

Take a closer look and these tax schedules aren't as transparent as the politicians selling them would have the public believe. Some skeptics question whether they're little more than short-term reform gimmicks that could ultimately prove unsustainable.

Few, if any, of the reforms in Central and Eastern Europe meet the definition of a true flat tax because they include deductions, exemptions, and other exceptions. This alone doesn't justify questioning their transparency, but deviations from the economics textbook don't stop there.

The Czech proposal is an example of a flat tax that doesn't exactly pass the transparency test. The measure has been sold as a simple 15-percent rate to replace the current four-tiered progressive scale of 12 percent to 32 percent. But because it actually taxes earners' "super-gross income," which includes contributions to health and social insurance, the effective rate is closer to 23 percent, a fact that "undercuts some of the flat tax's chief attributes -- simplicity and transparency," The Wall Street Journal observed recently.

Many of the reformers have slipped in similar social charges, and even Slovakia's 19 percent, which is clearly simpler than its former five-bracket system, isn't truly flat because it includes deductions and exemptions.

Laura Alfaro, an associate professor at Harvard Business School in the United States, and her colleagues at the school's Europe Research Center, noted this lack of "flatness" in researching a recent case study on Slovakia's tax reform.

"As we were doing it, we found out that it's not really about the flat tax, because in theory it should be the same rate for everyone, but some countries allow exemptions and deductions, and that's the case with Slovakia," Alfaro said. "It's a very imaginative way of selling a huge tax reform. It sounds like it gives a bit to everyone."

By "huge tax reform," Alfaro meant huge cuts, as the second wave of reforms that started with Russia in 2001 introduced significantly lower income taxes and often corporate taxes as well. So the term "flat tax" has of late been used more as code for lowering taxes, which, judging by the Czech Republic and Albania, remains the trend.

If, then, the flat tax is often nothing more than tax cuts in fancy dress, the resulting drop in revenues raises serious questions about how long governments can afford to embrace it.

LONG-TERM CHALLENGES

Proponents of the flat tax argue that a simplified system with a single rate, even a low one, can actually increase revenue by encouraging compliance. That theory, however, has not held up well to scrutiny. Among the countries in the second wave, only Russia saw revenue from personal income tax increase the year of the reform, and that may have had more to do with a "wider economic recovery," according to Keen's report.

Revenue from higher value-added and other taxes can offset losses, as happened in Slovakia. But this isn't going to sit well with the lower and middle classes, who spend a greater proportion of their income on consumption taxes, as they watch the welfare system deteriorate with the reforms.

Shriveling of the welfare state proved problematic in Slovakia, where large families in particular were hit with lower benefits. This is why Robert Fico vowed to abolish Slovakia's single rate during his run for prime minister in 2006. It's also why middle-class voters in Western Europe object to the flat tax, which they did during Angela Merkel's 2005 campaign for German chancellor.

For his part, Fico won the election but hasn't followed through on his promise. He and other Central European leaders may have to revise their tax schedules, however, under pressure from Western Europe. Several Western European leaders complain that the lower tax rates and labor costs give the newer European Union states an unfair advantage in attracting business, and some have threatened to seek cuts in EU funding for those countries.

If the second-wave reformers can't placate Western Europe, "Germany and France are going to say: 'We're not going to give you more aid,' " Alfaro said. " 'We're not going to give you structural funds.' "

Flat-tax proponents could argue that higher GDP growth and investment could pay for the costs of these reforms. But in the case of the Czech Republic, GDP would have to grow fast -- around 33 percent, Sedlacek estimates -- to offset revenue losses. Even Latvia, which outdid all the flat tax countries last year with 10.2 percent GDP growth, isn't approaching 33 percent.

And it's not even clear that companies prioritize corporate taxes when evaluating investment locations. Taxes can be pivotal, but political climate, infrastructure, and the quality of the labor force usually take precedent, which is why multinationals often favor the Czech Republic to, say, Romania, despite its considerably lower corporate tax rate of 16 percent. This is also the reason the World Bank consistently ranks Denmark and other Scandinavian countries among the best places in the world to do business despite their high taxation.

"What companies care most about is not taxes, but favorable government," said Sedlacek, who has worked with CzechInvest, the Czech Republic's inbound investment agency. "They want to know: 'Whenever we've got a problem, we can come to you, and you will help us.' "

DO YOU BELIEVE IN MIRACLES?

If the flat tax is over-hyped, what, then, explains the rapid economic growth, increased investment, and rounds of applause Slovakia and others have received from international economic monitors such as the World Bank?

For the most part, these countries were low-growth economies with exhausting bureaucracies that implemented large-scale, successful reform packages to kick-start the system -- and the flat tax is the most visible, promoted reform.

"Really, the flat-tax reforms have been used as a signal: 'We're open for business,' " Keen said. "Part of the difficulty is that there's so much else going on, so it's hard to say the flat tax leads to growth. Slovakia is an example of a country where there was a lot else going on."

Indeed, its unified 19-percent tax was one of many changes to the labor, health care, and pension systems, among others. Flat tax has gotten the most attention, but Slovakia and the other countries, especially of the second wave, may face problems as the short-term high fizzles. They could find themselves confronting an increasingly hostile Western Europe and an under-funded state politically unpopular at home and no longer as attractive to foreign investors, Alfaro said.

"No one's going to [a country] just for the taxes," she said. So "this might come back to haunt them. If they're not using their little resources to give people what they want, people might not want to go there."

FLAT-TAX COUNTRIES

First Wave:

Estonia: 1994, 26 percent income and corporate

Lithuania: 1994, 33 percent income, 29 percent corporate

Latvia: 1997, 25 percent income and corporate

Second Wave:

Russia: 2001, 13 percent income, 35 percent corporate (since reduced to 24 percent corporate rate)

Serbia: 2003, 14 percent income and corporate

Ukraine: 2004, 13 percent income, 25 percent corporate

Slovakia: 2004, 19 percent income, corporate, VAT

Georgia: 2005, 12 percent income, 20 percent corporate

Romania: 2005, 16 percent income and corporate

New Wave:

Czech Republic: 15 percent income this year, 19 percent corporate by 2010 (proposed)

Albania: 10 percent income and corporate in 2008 (proposed)


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