FLATTENING THE WORLD:

All Eyes on Slovakia's Flat Tax: Q&A with: Laura Alfaro, Vincent Dessain, and Ane Damgaard Jensen (Martha Lagace, April 30, 2007, HBS Working Knowledge)

The flat tax is an idea that's burst to life in post-communist Eastern and Central Europe, especially in Slovakia. But is the rest of the world ready? A new Harvard Business School case on Slovakia's complex experience highlights many hurdles elsewhere, as HBS professor Laura Alfaro, Europe Research Center Director Vincent Dessain, and Research Assistant Ane Damgaard Jensen explain in this Q&A.

Q: Could the flat tax only have been introduced in the context of other reforms that Slovakia was managing during its post-communism transition, such as labor reform and privatization?

Alfaro: It is true that the countries that have introduced a flat tax have all been in macroeconomic situations where something had to be done to foster growth and attract investments, which indicates a major trend for linking tax reform with, for instance, privatization and labor and welfare reforms. So existing evidence indicates that overhauling other parts of the public system, in order to afford a perceived cut in tax revenues through a flat tax implementation, is needed. This, however, does not indicate that the opposite is impossible.

It also has to be said that a lot of the appeal behind the flat tax is related to the reduction in the administrative burden, but also that flat taxes tend to be low. So one could question whether the theoretical flat part of the flat tax concept is in fact what has been attractive or whether the flat aspect has been a political way to sell the overall tax reform, and hence mostly low taxes.

Q: Can Slovakia serve as a model for other countries that are weighing a flat tax? If so, how should other countries learn from positives and negatives of the Slovak experience?

Dessain: Estonia, Slovakia, and other Eastern European countries are in fact already serving as models for other countries that are considering adopting a flat tax. The former Prime Minister of Estonia, Mart Laar, was the pioneer in Eastern Europe, implementing a flat tax in 1994. One of the fascinating aspects about the Estonian example is that Laar thought that a flat tax had already been tried and proved successful in Western economies, as the literature on the concept was widespread and it seemed so obvious to him what a flat tax could do. So he decided to give it a try. And this is essentially what he advocates: that countries should try it out. Laar has made a tour of many countries and recently paid a visit to Costa Rica to talk to government officials, members of congress, economists, and businesspeople about his country's experiences with the flat tax. He also gave advice on what he believed the flat tax should be linked with (privatization and access to a free trade area) in order to turn the economy around and make it grow.

Jensen: Former Finance Minister Ivan Mikloš, who introduced the flat tax in Slovakia, has also been a strong advocate for the wider spread of the concept. Martin Bruncko, a 2003 graduate of the Harvard University Kennedy School of Government and the chief economic adviser to Finance Minister Mikloš, has traveled extensively throughout Europe in order to explain what a flat tax is and what it can do. Interestingly enough, Western European countries are also listening. But again, the fact that many countries are thinking about adopting a flat tax may have something to do with finding a political way to implement low corporate tax rates. And there are fears of a race to the bottom. However, recent events in Slovenia might demonstrate a reversal in Eastern Europe. Slovenia is one of the smallest among the recent wave of EU entrants, and it is also the closest to the standards of living enjoyed in the more established EU countries. Slovenia rejected the flat tax, which is consistent with the aversion seen in some EU 15 countries.

Alfaro: Overall, other countries can look to Slovakia as a model of what might happen when a flat tax is adopted, as this example illustrates several aspects. The overall economic performance has improved: Real output growth in Slovakia was 8.2 percent in 2006—a record high. However, it is difficult to disentangle the effects of the flat tax from that of the other reforms. Clearly, a lesson to be learned from Slovakia is that such a drastic change to fundamental tax habits needs to be thoroughly explained to all individuals and groups affected by it. It has to be taken into consideration, however, that flat taxes in these countries were often made possible by the fact that tax collection had been limited under the communist regime, so in any case tax revenues were likely to increase. Recently, the government elected in June 2006 introduced some changes to the original reforms, even through these changes were, in the eyes of many, quite minor. But again, the case of Slovakia highlights that beliefs and views of a country on what is fair matter for the long-term sustainability of reforms.

Q: What do you think it would take for the idea of a flat tax to gain ground in the U.S. or Western Europe?

Dessain: Economists and business leaders alike are talking about flat taxes in many countries. As Western European countries lose ground vis-à-vis countries in Eastern Europe endowed with low tax rates, low salaries, and skilled labor, governments will increasingly look for ways to reform their tax and labor systems in order to attract business—or simply stop businesses from delocalizing. The direct effect of the Slovak flat tax can be seen in Europe, where neighboring Austria has lowered its corporate tax rate from 34 percent to 25 percent. This has been perceived by many as a clear sign that the Slovak reforms have been attractive to foreign investors. In response to broader initiatives, Germany has recently decided to reduce its corporate tax rate from 39 percent to below 30 percent in an effort to make the country attractive for investors.

Jensen: Similarly, voters in Finland decided to oust the ruling Social Democrats in favor of parties promoting tax cuts in response to the attraction of neighboring Estonia's flat tax. Most recently, the United Kingdom reduced its corporate tax rate from 30 percent to 28 percent and its income tax rate from 22 percent to 20 percent in an attempt to simplify the tax system. Still, the British government decided to reduce social security contributions and industry allowances, as the initiative was supposed to be revenue neutral.

Alfaro: In spite of these examples of tax reduction, there is a long way to go from lowering tax rates to introducing a flat tax in the U.S. or in Western Europe. This would require a change of attitude in countries marked by a substantial history with progressive taxation. To many, the concept of applying the same rate of tax to everyone regardless of income is simply not possible. Most certainly, the elimination of deductions and exemptions—such as mortgages, etc.—is a battle many politicians will not want to take on in the near future. Also, the argument that a flat tax is likely to be paid by the middle classes is probably one reason why the concept has yet to gain ground in the U.S. or in Western Europe; the middle class simply doesn't want it. As economist Joseph Schumpeter said, "The spirit of a people, its cultural level, its social structure, the deeds its policy may prepare—all this and more is written in its fiscal history."

One of the perverse ironies of the success of Ronald Reagan and George W. Bush is that our taxes are too low for us to care much about making the code more coherent.

Posted by Orrin Judd at April 30, 2007 12:00 AM