Around the World in 80 ideas

Around the World in 80 Ideas

ECONOMIC POLICY
49: One law for all
The flat tax proposal

The problem: tempting top taxes

Progressive taxes look fair. After all, wealthy people can afford to contribute more than others towards the cost of public services. But once the tax scale becomes progressive, it becomes essentially arbitrary, and politicians are tempted to keep on increasing the top rates so that the majority of taxpayers (and voters) do not feel that they are the cost of their high-spending programmes.

But to discriminate against a minority of the population, however wealthy, is arguably immoral. And the policy can quickly become counter-productive too, as high taxes cause people to move their capital abroad, retire early, or take (legal) avoidance or (illegal) evasion measures

The idea: everyone pays the same

The principle behind a flat tax is that it is a fairer and more efficient way of collecting revenue than the graduated taxes used almost everywhere. The idea has been widely advocated, especially in the United States, where it has featured on the agenda of Steve Forbes, a presidential contender in the 1990s. And now a number of smaller economies have taken the first steps toward putting the idea into practice.

The principle: fair and efficient

A flat tax derives in part from the work of US economist Arthur Laffer, who showed how revenues could rise as tax rates fell. The principle behind the 'Laffer Curve' is that lower tax rates boost economic growth, which yields higher revenues. They do this by making extra effort more worthwhile: extra work generates more benefit to the individual if it is taxed less. They also make avoidance and evasion less worthwhile by lowering the reward attached to them. They also increase tax revenues by broadening the tax base.

Harvard economist Lawrence Lindsay has calculated tax maximization rates. These vary according to where the current tax levels are fixed, but are invariably lower than any tax rates actually in use. His work was vindicated by the 1980s tax cuts of the Thatcher and Reagan governments. Tax rates were lowered substantially under both, and both countries saw increased revenues result. Furthermore, the proportion of total income tax paid by the top decile increased in each country (see the chapter Soak the Rich: Cut Taxes!).

A flat tax applies this principle. In place of all the high and varying rates, mitigated by numerous exemptions and allowances which bring employment to no-one but accountants and bureaucrats, a flat tax substitutes just one rate applicable to all income. It therefore brings administrative savings too, in that it is very much less complex and much less costly to administer than graduated rates and the exemptions, rebates, and concessions that go along with them.

It is also argued that the flat tax minimizes the impact of the tax system on economic behaviour. With high graduated taxes, a considerable part of business activity is directed towards lowering the tax profile, rather than to generating new orders. A flat tax imposed uniformly on all income does not make some types of activity artificially more rewarding than others. It is economically neutral.

There is a moral case for the flat tax, one at least as strong as the economic case. It is that it is fairer. Under a flat tax, everyone pays the same percentage. If taxes are to be raised, they are raised on everyone, and governments lose the temptation to hit some groups harder in order to buy the support of others. The argument is that people will accept the fairness of a single rate paid by everyone. Those who earn least money will pay least tax, and those who earn most money will pay the most.

To those who argue that 'the rich should pay even more', the reply of the flat taxers is that they will indeed pay even more. Under a flat tax, the top decile of earners will end up paying more in total, and will pay a higher share of the total tax take.

The actual level of the flat tax would depend on the perceived needs of government. The calculation made in the United States is that the flat rate which would raise the same revenue as the graduated taxes with their allowances and exemptions would be of the order of just 17 per cent. That is, a flat 17 per cent on income, universally applied, would raise what the US Internal Revenue takes in each year through its current high and complicated tax regime.

Given the economic boost which the lowered rates of a flat tax would bring, it is a means of boosting growth and creating wealth and jobs. With all this going for it, and with natural justice on its side, too, it is an idea which, when implemented, may leave people wondering what took them so long.

There are signs that the idea may be catching on. In 1994, the government of Estonia introduced a 26 per cent flat tax on company profits and personal incomes (see the chapter Small but Free) and abolished taxes on profits that were re-invested into the domestic economy, and introduced other, temporary tax holidays on company profit distributions. Another Baltic state, Latvia, followed with a 25 per cent flat tax a year later. At the other end of the European continent, Croatia then adopted a tax reform that embodies the core features of the flat tax. All have worked well. Three political parties in Poland aim to bring a flat tax proposal to the legislature there.

The boldest measures, however, were taken in Russia under President Putin. A 13 per cent flat tax on personal income came into effect in January 2001, replacing the old three-bracket system with its top rate of 30 per cent. By April 2001, the President was able to report that income tax revenues for the quarter were up 62 percent on the previous year.

For further information:

There are various think-tank reports on the flat tax idea. See for example: