Why the case for a flat-tax is irresistible

Flat Tax is spreading because it works. Regardless of any theoretical objection, it achieves the desired results. With the addition this yearof Romania and Georgia, there are now 11 countries using the system, with many more studying the idea very closely.

So what is it? In place of the various tax bands, exemptions and allowances that feature in a progressive tax regime, flat tax replaces them with a single rate. Typically, it excludes low earners from paying any income tax at all and sweeps away the tax allowances that made the graduated system so complex.It works on two levels. The single rate is set sufficiently low that compliance shoots up. It is less worthwhile to avoid tax by complicated tax shelters and less worthwhile to evade it by criminal failure to declare income. The second effect is that the low rate increases the reward of extra effort and risk-taking. Since people can now keep a higher proportion of what they earn, extra earning becomes more attractive.

Both the higher compliance and the expansion of economic activity contribute to broadening the tax base. This explains one of the most paradoxical features of flat tax: the fact that it rapidly brings in more revenue at the lower rate. It does so because the lower rate is charged on more income.

There is another paradoxical feature. A low rate of flat tax (with low earners exempted altogether) can rapidly lead to the rich paying not only more tax, but a higher proportion of the total. Something of this effect was seen following the UK’s tax cuts of the 1980s. The top 10 per cent of earners, who had contributed 32 per cent of income tax before the cuts, were contributing 45 per cent afterwards. US tax cuts have produced similar results.

Those who talk of raising Britain’s top rate from 40 per cent to 50 per cent say they want the rich to pay more. The reality is that tax revenues from the top earners might well decrease if they did so, whereas a cut in the top rate to 30 per cent would probably increase total revenue and raise the share of it paid by the rich.

Of course, there are theoretical objections to flat tax and John Kay has raised some of them (FT Feb 9). Critics say it is difficult to define what income is and that is why we need thousands of pages of tax regulations. But the overwhelming majority of people in Britain are paid wages or salary, perhaps with a few easily quantified benefits such as subsidised meals. For all but a tiny minority, their taxable income would be obvious.

Indeed, the same difficulties apply to the present system. Income is no more difficult to define under flat tax than it is now. It is easier.

It is the high tax rates that motivate people to seek out those exemptions and to shelter some of their income behind them. This is one reason the current system has become so cumbersome and complex over the years. The change to a flat tax represents the chance to sweep away the accumulated debris that has built up within the tax system over generations, just as privatisation enabled distortions and bad practices to be discarded from our state industries.

Some critics suggest that flat tax only works in smaller, less developed or transitional economies. It is true that its practitioners include several of the former communist states of Eastern Europe. But Hong Kong is by no means a less developed economy, nor is Russia a small one, and Hong Kong has had flat tax since 1948, Russia since 2001. China, no economic midget either, is considering the idea and it is attracting increased interest in the US.

There will be huge competitive advantages to the first of the advanced European economies to follow this route. The low tax rate will prove a magnet for high flyers and for those setting up new businesses. It will certainly cost much less to administer, too. There is more to flat tax than its financial and commercial attractions, however. Simplicity itself is a virtue in taxation. It is better that people should understand their obligations than that they should not.

Flat tax promises to cut the Gordian knot of tax complexity. Those who feel comfortable in that complexity might blanch at the prospect of a tax system at once simple and transparent. If this tax system also unleashes enterprise and boosts economic growth, the case for it grows irresistible.

Flat tax is not flat earth, as John Kay suggests. Rather it is feet on the ground.

Madsen Pirie is president of the Adam smith Institute