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Fri Apr 15 08:32:24 PDT 2005

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THE FLAT-TAX REVOLUTION
Apr 14th 2005  

Fine in theory, but it will never happen. Oh really?

THE more complicated a country's tax system becomes, the easier it is
for governments to make it more complicated still, in an accelerating
process of proliferating insanity--until, perhaps, a limit of madness
is reached and a spasm of radical simplification is demanded. In 2005,
many of the world's rich countries seem far along this curve. The
United States, which last simplified its tax code in 1986, and which
spent the next two decades feverishly unsimplifying it, may soon be
coming to a point of renewed fiscal catharsis. Other rich countries,
with a tolerance for tax-code sclerosis even greater than America's,
may not be so far behind. Revenue must be raised, of course. But is
there no realistic alternative to tax codes which, as they discharge
that sad but necessary function, squander resources on an epic scale
and grind the spirit of the helpless taxpayer as well?

The answer is yes: there is indeed an alternative, and experience is
proving that it is an eminently realistic one. The experiment started
in a small way in 1994, when Estonia became the first country in Europe
to introduce a "flat tax" on personal and corporate income. Income is
taxed at a single uniform rate of 26%: no schedule of rates, no
deductions. The economy has flourished. Others followed: first, Latvia
and Lithuania, Estonia's Baltic neighbours; later Russia (with a rate
of 13% on personal income), then Slovakia (19% on personal and
corporate income). One of Poland's centre-right opposition parties is
campaigning for a similar code (with a rate of 15%). So far eight
countries have followed Estonia's example (see article[1]). An old idea
that for decades elicited the response, "Fine in theory, just not
practical in the real world," seems to be working as well in practice
as it does on the blackboard.

PURE AND APPLIED
Practical types who said that flat taxes cannot work offer a further
instant objection, once they are shown such taxes working--namely, that
they are unfair. Enlightened countries, it is argued, have
"progressive" tax systems, requiring the rich to forfeit a bigger share
of their incomes in tax than the poor are called upon to pay. A flat
tax seems to rule this out in principle.

Not so. A flat tax on personal incomes combines a threshold (that is,
an exempt amount) with a single rate of tax on all income above it. The
progressivity of such a system can be varied within wide limits using
just these two variables. Under systems such as America's, or those
operating in most of western Europe, the incentives for the rich to
avoid tax (legally or otherwise) are enormous; and the opportunities to
do so, which arise from the very complexity of the codes, are
commensurately large. So it is unsurprising to discover, as experience
suggests, that the rich usually pay about as much tax under a flat-tax
regime as they do under an orthodox code.

So much for the two main objections. What then are the advantages of
being very simple-minded when it comes to tax? Simplicity of course is
a boon in its own right. The costs merely of administering a
conventionally clotted tax system are outrageous. Estimates for the
United States, whose tax regime, despite the best efforts of Congress,
is by no means the world's most burdensome, put the costs of
compliance, administration and enforcement between 10% and 20% of
revenue collected. (That sum, by the way, is equivalent to between
one-quarter and one-half of the government's budget deficit.)

Though it is impossible to be precise, that direct burden is almost
certainly as nothing compared with the broader economic costs caused by
the government's interfering so pervasively in the allocation of
resources. A pathological optimist, or somebody nostalgic for Soviet
central planning, might argue that the whole point of the myriad
breaks, deductions, allowances, concessions, reliefs and assorted other
tax expenditures that clog rich countries' tax systems--requiring total
revenues to be gathered from a narrower base of taxpayers at
correspondingly higher and more distorting rates--is to improve
economic efficiency. The whole idea, you see, is to allocate resources
more intelligently. Yes, well. Take a look at the current United States
tax code, or just at one session of Congress's worth of tax-gifts to
favourite constituencies, and try to keep a straight face while saying
that.

THEY CANNOT BE SERIOUS
Once tax codes have degenerated to the extent they have in most rich
countries, laden with so many breaks and exceptions that they retain
nothing of their original shape, even the pretence of any interior
logic can be dispensed with. No tax break is too narrow, too squalid,
too funny, to be excluded on those grounds: everybody is at it, so why
not join in? At the other extreme, the simpler the system, the more
such manoeuvres offend, and the easier it is to retain the simplicity.

In Britain, election notwithstanding, tax simplification is nowhere on
the agenda: why not? George Bush has at least appointed a commission to
look into tax reform. But its terms of reference are so narrow that it
could not suggest a flat tax even if it wanted to. This is a great
pity. A flat tax would not eliminate the need for spending control; it
would not deal with the impending financial distress of Social Security
and Medicare; it would not even settle the arguments about the
so-called consumption tax (since in principle a flat tax could take as
its base either all income, or income net of savings, in which case it
would act as a consumption tax). There are things it cannot do and
questions it does not answer. But the gains from a radical
simplification of the tax system would be very great. The possibility
should not be excluded at the outset. 

It is true that the flat-tax revolutionaries of central and eastern
Europe are more inclined to radicalism than their politically maturer
neighbours to the west and across the Atlantic. Mobilising support for
sensible change is far harder in those more advanced places--but not
impossible. In tax reform, as 1986 showed, the radical programme can
suddenly look easier to implement than the timid package of piecemeal
changes. Now and then, the bigger the idea, and the simpler the idea,
the easier it is to roll over the opposition. The flat-tax idea is big
enough and simple enough to be worth taking seriously. 

-----
[1] http://www.economist.com/displayStory.cfm?story_ID=3860731

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