The rich will pay more if you tax them at a flat rate

Shortly before the US election, President Bush listed his domestic priorities to the New York Times. “I’m going to come out strong after my swearing-in,” he said, with “fundamental tax reform, tort reform, privatising of social security [pensions].”

That first priority is particularly interesting, because many of Bush’s economic advisers are urging him to tear up the 55,000-odd pages of the US tax code and to follow the lead of nine other countries by replacing it with a simple, flat-rate tax.

Indeed, that is what his own administration has done in Iraq. Two months ago, Paul Bremer, administrator of the Iraqi Provisional Authority, signed an order establishing at 15% flat-rate tax in that country from 1 January. So who knows, Bush’s planned US tax reform might be “fundamental” indeed.

The idea of the flat tax is that everybody above a set threshold pays the same rate of tax. You simply scrap the complicated banding system of progressive rates, where big earners pay a higher rate of tax than middle earners, middle earners pay a higher rate than low earners. Out go the intricate adjustments depending on people’s age or marital status, and all the other exemptions, concessions and rebates deemed necessary to make a progressive tax system look remotely fair. With flat tax, the poor pay nothing.

And if the flat tax is back in fashion, it is because all of the nine countries that currently levy it have discovered it works. Three British outposts started things off. Hong Kong’s 1947 Inland Revenue Ordinance created a system that allows people to choose whether to pay a flat rate or to stick with the progressive system. Jersey in 1940 and Guernsey in 1960 switched from the British tax code to a flat rate of 20% on both individual and corporate income.

But more recently it is Russia and several of the former Soviet-bloc countries that have shown the world the potential of the flat tax. The Baltic states of Estonia, Lithuania and Latvia, plus Slovakia – all members of the European Union (EU) – have adopted it. So has Russia – a Group of Eight country – and Ukraine. And in every case they are feeling the benefit.

They have found that when you scrap all the complex rules and loopholes, you can set quite a low rate. Most of them have rates around 20%, though Russia leads the pack with just 13%. And when rates are that low, it is not worth people trying to evade it.

In a progressive system, failing to report a dollar’s worth of income might save you 50 or 60 cents, making evasion attractive. But it is not worth the risk of being caught if an unreported dollar saves you only 13 cents. Nor, if you want to stay legal, is there much point in hiring expensive advisers and setting up elaborate tax shelters.

Countries such as Britain, where the progressive tax system is particularly complicated – the tax-adviser’s bible, Tolley’s Tax Guide, now runs to 7,344 pages across four volumes – end up supporting an entire industry of lawyers and accountants, all devising elaborate avoidance schemes, often parking clients’ money offshore. But again, if all this feverish avoidance saves you only 13%, it becomes hardly worthwhile.

So the flat-tax countries are finding that – despite their low rates – revenues are increasing. Slovakia, which in October 2003 agreed a 19% flat tax on personal and corporate incomes – replacing an old system with a top rate of 38%, 90 exemptions, 19 potential sources of untaxed income, 66 tax-exempt items, and 27 items with specific tax rates – is a case in point. Slovakia’s finance minister, Ivan Miklos, told me: “I lost three nights’ sleep worrying about this proposal, which I expected not to be popular. But then I reasoned that keeping our old system would be even more unpopular, so we just did it.” Now, he says, the combined revenues from income tax and all the taxes he cut, are rising.

Russia found just the same after it scrapped its complicated system. In 2001, the first year under its flat tax, income-tax revenues were 28% higher than in 2000, and rose 21% in 2002 compared with 2001. In 2003 they rose even more.

The fact that low tax rates produce higher revenues puzzles politicians – even though it should be obvious that when rates are high, people will work less, avoid and evade more, and so pay less tax in total. Not just the new flat-tax countries, but even traditional countries such as America and Britain provide ample proof of it.

In the early 1920s, US President Calvin Coolidge cut the top rate of tax from 73% to 25%. Revenues increased as the US economy boomed. In the 1960s, John Kennedy cut the top rate from 91% to 70%: again, the economy prospered and revenues rose. Over the 1980s, following Ronald Reagan’s drastic pruning of the top rate from 70% to just 28%, total tax revenue nearly doubled.

It used to be thought that a flat tax would benefit only the rich. But in fact, low tax rates leave the rich paying more of the revenue. In 1979, the richest 10% of the UK’s earners paid around a third (35%) of all income tax. When Margaret Thatcher became prime minister she slashed the UK rate from 83% to just 40%. By the end of the Conservatives’ administration in 1997, the top 10% of earners were paying nearly a half (48%) of all income tax. Escaping the tax had become less than half as worthwhile. The same thing happened with each one of the United States tax cuts. And now the flat-tax countries are finding the same: when rates are low and flat, the rich pay more.

The transparency of the flat tax is also boosting competition between countries. The Estonians have found Russia and Latvia so successful at stealing business away from them – and see a further threat looming from Slovakia – that they now plan to cut their 26% flat-tax rate to 20%.

The message has not been entirely lost on Old Europe, either. Germany’s Chancellor Gerhard Schröder berated the Slovakians for introducing such a low rate, but now his own government has cut its rates for higher and lower earners, and is increasing untaxed allowances too. Even socialist Greece is making cuts.

Flat tax is back in fashion because it is clearly not just a rich man’s dream (as some thought when multimillionaire Steve Forbes made it the basis of his 1996 US presidential bid). On the contrary, the rich pay more, while the poor pay nothing. But it does promote enterprise and growth. Income is taxed only once, so the double-taxation on savings and investments is ended. Less time is wasted filling in forms or trying to escape tax. A simple and transparent tax system is more attractive to foreign investors.

A British or US flat tax might come in at around 20%. And just in case Bush or Blair are not fully convinced of its merits, they should reflect that the idea is even being discussed in China. Now a quarter of the world’s population signing up for the flat tax really would be a “fundamental reform” of taxation.

Dr Eamonn Butler is director of the Adam Smith Institute. This article was originally published in The Business on 21 November 2004.