SIMPLIFY, ONLY SIMPLIFY:

The flat-tax revolution: Fine in theory, but it will never happen. Oh really? (The Economist, Apr 14th 2005)

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). 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.

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.

You can't be falling behind Romania...

Posted by Orrin Judd at April 21, 2005 12:00 AM