Taxing income at a flat rate, where everyone pays at the
same rate no matter the income level, is a bad idea that refuses to die. In the 2016 campaign for the Republican
nomination for president no less than four candidates proposed taking the
country to some version of that scheme.
T. R. Reid examines the consequences of such an approach in his recent
book A Fine Mess: A Global Quest for a Simpler, Fairer, and More Efficient Tax System.
Unbeknownst to most of us, a number of countries in central Europe have
actually tried such a plan. Reid
provides some background on the concept and lets us know how that approach
worked when actually put into practice.
One reason that flat-rate
proposals continue to be promoted is that they are very popular with people
possessing the money required to purchase the allegiance of politicians. The hope is always the same: that the public
would be deceived by the misleading appearance of fairness for what is really a
tax break for the wealthy and a transfer of tax burden to those with lower
incomes.
“….flat-tax
plans have generally been promoted by high-income taxpayers, by the think tanks
and political candidates they fund, and by their supporters in Congress. Of all the advocates, the most visible and
exuberant has been Steve Forbes, an extremely high-income taxpayer who
inherited a family business (Forbes
magazine) and a family fortune from his father, Malcolm Forbes. Steve Forbes ran twice, on a flat-tax
platform, for the Republican nomination for president….He wrote a book about
his plan, titled Flat Tax Revolution….”
Forbes suggested a flat tax of
about 17% on all earned income that would be accompanied by an elimination of
most other taxes and tax deductions.
This would have led to a severe shortfall in government revenue, but we
were told to not worry. Republicans
turned then to a scam that they have continued to promote no matter how many
times it has been proven to be false.
“So
they came up with an argument that says cutting taxes wouldn’t reduce the
revenues that fund government programs. ‘A
flat tax that combines stark simplicity with a tax cut would generate more, not
less, government revenue,’ Forbes maintained in his book. This would occur, the advocates say, because
lower taxes would have a dynamic impact on the economy, prompting people to
work more, to start new companies, to do more business. With this flat-tax boom, people’s incomes
would grow so much that they would end up paying more taxes, even at sharply
lower rates. By the same reasoning, a
tax increase would lead people to work less and thus shrink the economy.”
Republicans are still pushing
this concept today as they strive to lower taxes for the wealthy while claiming
revenue would increase from enhanced economic growth. Today it is referred to as “dynamic scoring.” Their problem now is finding credible
economists who will endorse this nonsense.
To learn how a flat tax approach
works in practice, Reid provides the experience of the central European
countries that were suddenly released from communist control with the
dissolution of the Soviet Union. These
countries had to quickly acquire the structures needed for a modern economy and
a modern government. In the process
Estonia decided to utilize the simplest income tax system possible: a flat tax,
even though all the economic advisors counseled against it.
“In
1994, the….government dropped Estonia’s three-bracket progressive income tax
structure and replaced it with a single 26% tax rate that applied to both
personal income and corporate profits.
This….was electrifying news for proponents of the flat tax in the West;
it immediately made an obscure place called Estonia stand out from all the
other former Soviet states."
At the time, income was low and
there did not yet exist a wealthy class in the nation; the flat rate made
little difference. But Estonia grew, and
as all countries that begin growing from a very low level, the rates of growth
were impressive. The Estonians managed
their economy well and took advantage of their low wages relative to the western
European nations.
“As
long as the local and global economies were growing, or at least fairly stable,
the flat tax nations of eastern Europe were doing well. Many were attracting investment; the
combination of a low, flat-rate tax system, cheap labor rates, and minimal
government regulation drew in large sums of foreign money.”
Other neighboring nations wished
to follow Estonia’s example and assumed a flat tax was an important component
of its success. Reid lists the countries
that moved to a flat tax and the year the move occurred: Estonia (1994),
Lithuania (1995), Latvia (1995), Russia (2001), Ukraine (2003), Serbia (2003),
Slovakia (2004), Georgia (2005), Romania (2005), Czech Republic (2008),
Bulgaria (2008).
“‘At
the stroke of a pen,’ the Economist
reported, ‘this tiny Baltic nation transformed itself from backwater to bellwether,
emulated by its neighbors and envied by conservatives in America who long to
flatten their own country’s taxes’.”
Just providing jobs for a poor country is sufficient at
first, but once the jobs come then pensions and healthcare and a host of other
issues need to be addressed. The role of
government must increase as well as the revenue needed to run it. Also, natural economic evolution produced an
unequal income distribution with a significant collection of wealthy
elites. In raising taxes with a flat
tax, a few percent increase will barely affect the wealthy, but at the lower
incomes the tax becomes unbearable and more and more people must be relieved of
the full tax rate. It becomes a very
inefficient way to increase revenue.
“In practice, you can’t find a single
tax rate that is high enough to raise the revenues you need but low enough for
average working people to afford. As a
fiscal matter, governments needed the higher revenues that would come from
imposing higher taxes on the upper brackets.
As a political matter, there was also a question of fairness. The boom years at the start of the
twenty-first century had created a class of ‘oligarchs’….in many of the former
Soviet countries. This created political
demands to go after the wealthy and make them pay more.”
After the Great Recession some sources of funds began to
disappear as other nations cut back on investments and began to consider the
eastern European countries more as competitors than countries in need of
assistance.
“Financial aid from the European
Union, which had been substantial for all of eastern Europe in the first
post-Soviet years, began to dry up. The
rich nations of western Europe, watching the low tax countries to their east
luring away wealth and investment, were no longer willing to finance nations
they viewed as economic competitors.”
In order to keep the flat-tax structure, nations had to
increase revenue by increasing taxes in other ways.
“They raised the VAT rate which
increased consumer prices; nearly all the eastern European countries have sales
taxes in the range of 20%. Hungary
imposed the world’s highest rate of sales tax, 27%, to make up for the revenue
shortfall of its flat-rate income tax.”
“Most of the flat-tax countries
jacked up their Social Security taxes.
In the United States, the Social Security tax on wages is 15%, with half
paid by the worker and half paid by the employer. By comparison, Estonia had to raise its
Social Security tax to 34%, all of it paid by the employer. The payroll tax for Social Security in
Slovakia went to 47.6%, paid mostly by the employer; in the Czech Republic, the
tax was 45.5%, with the worker paying 11.5% and the employer paying 34%.”
Economists argue that the best tax system is the one that
produces the least economic disincentives.
Jacking up the sales tax inhibits consumption; jacking up the Social
Security tax inhibits hiring. This seems
a high price to pay for maintaining a system that mainly benefits the
wealthy. In the fallout from the Great
Recession, people are very conscious of the fact that the wealthy seemed to have
fared better than the average citizen and think it is time for them to pay a
greater share.
Slovakia and the Czech Republic have already added some
progressivity into their income tax structure, and other countries seem to be
headed in that direction. Estonia is
still reluctant to give up on what had become its signature characteristic; but
the pressures are building. Reid
provides a summary quote from Professor Victor Forsberg, an economist at
Estonia’s University of Tartu.
“’I don’t think there is a
single serious economist in this country who would advocate keeping the
flat-rate tax,’ said Victor Forsberg….’You have to look at what we pay for
it. To make up for the lost revenue, we
had to raise the VAT tax to 20%. That
discourages people from buying. To make
up for the lost revenue, we have to charge employers 34% of any worker’s wages
to fund our social and health-care programs.
No wonder we have an unemployment problem! Anybody who wants to hire you has to pay not
only your salary but an additional 34% to the government’.”
“’What we don’t need is a single
rate of tax for everybody,’ the professor continued, his voice rising. ‘What we do need is to reduce the Social
Security taxes, to make it cheaper to hire and get people back to work! What we need is a lower sales tax, to get
people to spend! And the way you pay for
all that is the way every wealthy country in the world does it—with progressive
taxes!’”
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