Nor are flat taxes synonymous with low taxes. Certainly, most countries have cut their tax rates as they have flattened them. In 1994, Ukraine's top rate reached the stratospheric level of 90%, before descending, in stages, to its current single rate of 13%. But Lithuania's 33% flat rate is too high for some American conservatives.
Nevertheless, Lithuania's example might make flat taxes more palatable to the social democrats of western Europe. Miguel Sebastin, an economic advisor to Spain's socialist government, has advocated (largely in vain to date) a flat tax of 30% on Spanish incomes. Last year, a panel of academics set up by Germany's finance ministry also proposed a 30% flat tax on all personal and corporate income.
Flat taxes differ in scope as well as height. Since 2001, Russia has imposed a single 13% tax rate on all personal income. But it has a different rate for corporate profits: 35% at the time of its 2001 reform. Slovakia's flat tax, by contrast, covers both personal income and corporate income, as well as VAT. Taxing pay packets and profits at the same rate discourages an obvious form of tax arbitrage. For example, it was reportedly quite common for Slovak salarymen to declare themselves self-employed, while continuing to work for the same company much as before. Their wages would then be taxed as profits. Not only that, their lunch could be counted as a business expense.
Unfortunately, Slovakia's fiscal purism is somewhat adulterated by a heavy payroll tax. The social-security contributions of employees and employers combined amounted to almost half of labour income in 2004. Since this burden falls on earnings from work, not from capital, it restores the incentive for Slovaks to convert one into the other, by declaring themselves self-employed subcontractors. It may also drive some economic activity into the shadows, where the social-security agency cannot find it.
At the time of its reform, Estonia also taxed labour and capital at the same rate. After 2000, however, it chose not to tax profits at all until they are distributed to shareholders as dividends. This gives companies an incentive to retain their earnings and reinvest them. Indeed, very little of the burden of taxation in Estonia falls on corporations directly: corporate taxes accounted for only 3.6% of total tax revenues in 2003.
Estonia's economy has grown impressively since its 1994 reform. Growth reached double digits in 1997, and has since settled at around 6% annually, after a slump at the turn of the century. Repealing its high tax rate on the rich did not erode the country's tax base as some might have feared. In 1993, general government revenues were 39.4% of GDP; in 2002, they were 39.6%. Estonia now plans to cut its flat tax from 26% to 20% by 2007.
But how much do Estonia's robust revenues owe to its flat income tax? Perhaps less than is frequently advertised. In 1993, the year before its reform, Estonia's multiple personal income taxes raised revenues amounting to 8.2% of GDP. In 2002, its flat income tax raised revenues worth just 7.2%. Indeed, the flat income tax that generated so much excitement abroad seems to be carrying less weight than Estonia's old-fashioned VAT, which raised 9.4% of GDP in revenues in 2002.
VAT is, of course, the flattest tax of all. It levies a uniform rate on the goods you buy, taking a constant cut of your money when it is spent as opposed to when it is earned. Estonia's VAT is also quite broad, leaving relatively few things out (hydropower and windpower were two curious exceptions). The same point could be made about Slovakia. At 19%, it has a relatively low rate of income and corporate taxes, but one of the highest rates of VAT in Europe. It may be this high rate of VAT, not the flattening of its other taxes, that sustains the government's revenues in the future.
Flat taxes on the steppes
The most remarkable turnaround in government revenues was recorded in Russia. Prior to its 2001 tax overhaul, the federal government's tax-raising powers were rapidly deserting it. Clifford Gaddy and William Gale of the Brookings Institution report that tax arrears amounted to 34% of collections in 1997. By 1998, federal revenues had fallen to just 12.4% of GDP, leaving the government unable to pay its creditors. Investigators appointed by the president revealed that Russia's biggest enterprises ignored 29% of their taxes and paid another 63% in kind, with goods and services the government might or might not want. In lieu of $80,000 in taxes, one company reportedly offered the government ten tonnes of toxic chemicals.
On January 1st 2001, Russia flattened and broadened its personal income taxes, collapsing 12%, 20% and 30% bands into a single, uniform 13% rate. The state also withheld taxes at source, identified taxpayers by number, and audited suspected tax-dodgers. Messrs Gaddy and Gale note that no tax system could hope to bring in much revenue without these rudimentary instruments of tax enforcement.
How did revenues respond? A year after the reform, the personal income tax was raising almost 26% more revenue in real terms. Some of this was due to the rebound in the economy: real wages grew by 12% that year, and the take from all taxes, flat or otherwise, consequently improved. But the surge of rubles encouraged by the flat tax was more sustained.
A careful study by two IMF economists, Anna Ivanova and Michael Keen, together with Alexander Klemm, of the Institute of Fiscal Studies in London, tries to unearth the causes of this pleasant fiscal surprise. They find little evidence that Russians, freed from the yoke of progressive taxation, suddenly started working much harder. This is perhaps not surprising, as Russia's reform actually raised personal income taxes for the many households that previously fell into the 12% bracket.
They did discover a conspicuous increase in compliance with the tax authorities, however. In the year before the flat tax, Russians in the two higher tax brackets reported only 52% of their income to the taxman. In 2001, after falling into the new, all-encompassing 13% bracket, these same households reported 68%.
Many advocates of the flat tax, particularly in America, argue that it sharpens the incentive to work. A progressive income tax, they claim, deters extra effort from society's best-paid (and therefore most productive) members. Russia's experience, however, suggests that the principal virtue of the flat tax is its simplicity. The government's revenues did not surge because Russians suddenly squared their shoulders and straightened their backs. Rather, Russia's tax system became easier to administer and easier to comply with.
America is not Russia. It has a functioning tax system, albeit a clumsy one, so has something to lose from uprooting its tax system and starting again. But the potential gains are not negligible. In a typical year, the IRS estimates that for every dollar it collects, another 19 or 20 cents is owed, but not paid. This shortfall amounted to between $312 billion and $353 billion in 2001. Small businesses fail to report about 30% of their earnings. Babysitters and gardeners fail to report 80%, says the IRS.
In part, the tax system is burdensome because people dodge it. Every loophole that is exploited must be plugged. Every blurry line that is crossed must be sharpened. But Messrs Owens and Hamilton worry that the tax-codifiers and the tax-dodgers are locked in a mutually destructive arms race. The code is made more complex, because of tax wheezes. More people then seek to avoid taxes. The best way to fight tax avoidance, then, is with simplicity.
As every American knows, their country was founded in the wake of a tax revolt. What most forget is that the so-called Boston tea party, a raid on the cargo of British ships in Boston harbour, was not provoked by a tax hike. The British had in fact scrapped duties on tea, cutting out commercial middlemen. It is not going too far, then, to suggest that the American Revolution was provoked by a simplifying tax reform.