Flat Tax is the Way of the Future


Flat Tax is the Way of the Future

Mar 20, 2006 6 min read

Former McKenna Senior Fellow in Political Economy

Daniel is a former McKenna Senior Fellow in Political Economy.

Thanks to globalization, many nations are adopting better tax policies. Certain politicians still believe in high tax rates, of course, but they feel compelled to move in the opposite direction since it is now increasingly easy for labor and capital to escape oppressive tax regimes by crossing national borders.

This is why so many nations had to lower personal income tax rates after the Thatcher and Reagan rate reductions - and why many nations have been lowering tax rates on business in response to Ireland's incredibly successful 12.5 per cent corporate tax. They know the geese that lay the golden eggs will fly away if they impose bad tax law.

Economists like tax competition because it leads to better tax policy. Two of the most important rules of good tax law are low tax rates and less double taxation of saving and investment. Fiscal rivalry between nations leads them to adopt both.

Maximum personal income tax rates, for instance, are 23 percentage points lower today in developed nations than they were back in 1980.Corporate income tax rates have dropped by almost 20 percentage points. And many nations, including Scandinavian countries, are reducing tax rates on individual capital income and lowering taxes on wealth.

All these reforms boost economic performance by lowering the marginal tax rate on productive behavior. It is no surprise that nations that enact these policies grow faster and create more jobs.

Governments that try to keep tax rates high, by contrast, suffer from stagnation and joblessness. Politicians from these countries whine about ''harmful'' tax competition from Ireland, Slovakia, Estonia, and the United States, but they should look in the mirror if they want to find who really deserves to be blamed.

Instead of fighting to preserve existing tax systems that punish job creation and success, governments should make a virtue out of necessity and adopt pro-growth tax reforms. Ideally, they should scrap their tax codes and implement a flat tax. About a dozen nations already have implemented this simple and fair tax code, and the list gets longer every year - thanks to tax competition.

How would a flat tax work for individual taxpayers?

Compared to traditional tax systems, a flat tax is extremely simple. Households get only one exemption -a generous allowance based on family size - and then pay a low rate on any income above that amount.

They do not need to worry about reporting dividends, interest and other forms of business/capital income. Those forms of income are taxed at the business level, thus obviating any need to tax them at the individual level since that would violate the principle of no double taxation.

How would a flat tax work for businesses? All businesses, from the largest multinational to a corner pub, would play by the same rules. Companies would add up their receipts (how much revenue came in) and then subtract their costs (salaries, cost of raw materials, and expenses for new tools and machinery).

This would give them their taxable income, which would be taxed at the low rate.

What are the advantages of a flat tax?

There are two principal arguments for a flat tax- growth and fairness. Many economists are attracted to the idea because current tax systems, with high rates and discriminatory taxation of saving and investment, reduce growth, destroy jobs and lower income. A flat tax would not eliminate the damaging impact of taxes altogether, but by dramatically lowering rates and ending the tax bias against saving and investment, it would boost an economy's performance.

However, the most persuasive feature of a flat tax for many people is its fairness.

The complicated documents, instruction manuals and numerous forms that taxpayers struggle to decipher would be replaced by a brief set of instructions. The entire tax code could be based on two simple postcard-sized forms.

This radical reform appeals to citizens who not only resent the time and expense consumed by filing their own tax forms, but also suspect that the existing maze of credits, deductions and exemptions gives a special advantage to those who wield political power and can afford expert tax advisers.

If enacted, a flat tax would yield major benefits, including:

Faster economic growth. A flat tax would spur increased work, saving and investment.

By increasing incentives to engage in productive economic behavior, it would also boost the economy's long-term growth rate.

Instant wealth creation. All income-producing assets would rise in value since the flat tax would increase the after-tax stream of income that they generate.

Simplicity. Complexity is a hidden tax that requires record-keeping, form preparation, lawyers, accountants and other resources to comply with the current system.

Fairness. A flat tax would treat people equally. A wealthy taxpayer with 1,000 times the taxable income of another taxpayer would pay 1,000 times more in taxes.

No longer would the tax code penalize success and discriminate against citizens on the basis of income.

An end to micromanaging and political favoritism. A flat tax gets rid of all deductions, loopholes, credits and exemptions.

Politicians would lose all ability to pick winners and losers, reward friends and punish enemies, and use the tax code to impose their values on the economy.

Increased civil liberties. A flat tax would eliminate almost all sources of conflict between taxpayers and the government.

Moreover, infringements on freedom and privacy would fall dramatically, since the government would no longer need to know the intimate details of each taxpayer's financial assets.

Global competitiveness. In a remarkable development, former communist nations are leading a global tax reform revolution. Estonia was the first to adopt a flat tax, implementing a 26 per cent rate in 1994, just a few years after the collapse of the Soviet Union. The other two Baltic republics of the former Soviet Union enacted flat taxes in the mid-1990s, with Latvia choosing a 25 per cent rate and Lithuania picking 33 per cent. Along with other free-market reforms, the flat tax significantly improved economic growth, and the 'Baltic Tigers' became role models for the region. Learning from its neighbors, Russia stunned the world by adopting a 13 per cent flat tax, which went into effect in 2001.

The Russian flat tax quickly yielded positive results: the economy prospered and revenues poured into government coffers since tax evasion and avoidance became much less profitable. The flat tax then spread to Serbia, which in 2003 chose a 14 per cent rate. Slovakia hopped on the bandwagon the following year with a 19 per cent flat tax, as did Ukraine, which chose a 13per cent rate. Earlier this year, Romania joined the flat tax revolution with a 16 per cent tax rate, and Georgia adopted a 12per cent rate. This year, Kyrgyzstan adopted a 10 per cent flat tax, giving it the honor, at least temporarily, of having the lowest rate in the world.

The flat tax revolution has been so successful that Estonia is lowering its rate to keep pace with other nations: it is now down to 24 per cent and will drop to 20 per cent by 2007.Lithuania is in the process of lowering its 33 per cent flat tax to a more reasonable 24 per cent, and the Latvian government wants to reduce its tax rate from 25 per cent to 15 per cent.

Lawmakers in Croatia, Slovenia, Bulgaria and Hungary are also considering tax reform. Last but not least, the opposition parties in the Czech Republic have promised to implement a 15 per cent flat tax regime if they win the upcoming elections.

No discussion of the flat tax is complete without a mention of Hong Kong. After World War II, Hong Kong was one of the poorest places on the planet. But a flat tax was adopted in 1947, and this system - combined with other free-market policies - led to dramatic increases in economic performance. Today, Hong Kong's optional flat tax (taxpayers can choose to participate in a so-called progressive scheme) should serve as a role model for other jurisdictions.

Traditional income tax systems punish the economy, impose heavy compliance costs on taxpayers, reward special interests and make a nation less competitive. A flat tax would dramatically reduce these ill effects.

More importantly, it would reduce government power over the lives of taxpayers and get it out of the business of trying to micromanage the economy.

There will never be a tax that is good for the economy. But the flat tax moves the system much closer to where it should be - raising the revenues that government demands, but in the least destructive and least intrusive way possible.

Daniel J. Mitchell is McKenna senior fellow in political economy at The Heritage Foundation.

First appeared in the Sunday Business Post (Ireland)