Assessing Flat Taxes

In the last decade, the list of countries where taxes are ‘flat’ (a tax system which taxes incomes and profits, beyond a certain threshold, at the same rates) has been growing. Flat taxes, it is argued, do two things: they reduce tax evasion and they induce middle to high-income earners to work harder (supply-side effects). These boost government finances and economic growth. Countries that have adopted flat taxes provide experimental material for testing these claims. Baltic countries, like Estonia and Lithuania, and Russia have reported significant increases in government income after introducing flat taxes. However, it is often argued that there may be other factors at play. An IMF study of Russia in 2005 shows that there is no evidence that flat taxes have had supply-side effects, and that the improvements in public finances and of the economy are likely to be the consequence of high oil prices. In a recent paper given at an NBER Conference last week, Gorodnichenko, Martinez-Vasquez and Sabirianova Peter make a similar claim: flat taxes had very little supply-side effects in the Russian case. But, they argue, they have led to a significant reduction in tax evasion. So, where do we stand on flat taxes?

There are two distinct facts that require attention. (1) The fact that adopters have ‘flattened’ their tax schedule: i.e. except for a personal allowance that limit taxes paid by low-income earners, taxes increase uniformly with income and profits. (2) The fact that adopters have reduced their tax rates dramatically (all of them have slashed top tax rates of 30-35%, to rates below 20%). Making the distinction is important as ‘flatness’ has to do with the trade-off between efficiency and equity, while ‘lowness’ has to do with the trade-off between the public finances and supply-side stimulus.

For some, flatness has a real trade-off: it improves efficiency, by reducing administrative costs, tax evasion and wasteful tax arbitrage, but, by limiting progressivity, it limits the scope for redistribution. For others however, it is a ‘win-win’ policy: with personal deductions set high enough and increased tax compliance, it can in fact be more progressive than tax regimes that are in fact progressive but burdened with exemptions and deductions of all sorts.

Similarly, some may argue while ‘low’ taxes may give some incentives to work harder, they affect public finances negatively (and hence impact on essential public services, such as education and health care). Others argue that ‘low’ taxes pay for themselves: more work means more taxes and more revenue for the government. Others still would argue that it may not be a bad thing for governments to limit the size of their revenues as this would induce them to spend wisely.

A 2006 IMF Working Paper by Keen, Kim and Varsano summarises the empirical evidence on each of these aspects.:

Efficiency and Flat Taxes:

…there is evidence for Russia that compliance did improve. This evidence of an increase in compliance in Russia is quite impressive. Indeed it may seem surprising so, given that the sample used essentially comprises workers liable to deduction at source…where tax implementation has become largely dysfunctional, escaping tax is an inconvenience rather than a gamble. If so, then the presumption is indeed that reduced tax rates will lead to increased compliance.

Progressivity and Flat Taxes:

For Russia, the 2001 reform was associated with increased progressivity … at least with respect to the distribution of wages…The Slovak tax reform appears to have made the distribution of tax payments more unequal, in that sense enhancing progressivity. It is likely to be difficult to explain to the non-economist how a tax reform that involves a substantial tax reduction for the highest earners can be an increase in tax progressivity.

[However], in each of these cases, the effect of the flat tax cannot have been an unambiguous increase in progressivity, since in each case the average tax rate on the highest incomes fell.

Public Finances and Low Taxes:

Except in Latvia, Lithuania—which both set the flat tax rate at the highest marginal tax rate prior to reform—and in Russia, adoption of the flat tax was followed by a reduction in PIT [Personal Income Tax] revenue. Base-broadening and behavioral responses (whether in terms of increased labor supply or improved compliance) seem not to have been enough to offset the effects of rate reductions

Economic Stimulus and Low Taxes:

The broad consensus is that the effects of tax changes on the effort of primary workers are modest (reflecting offsetting but perhaps large income and substitution effects). [There is] no evidence that the Russian tax reform had strong effects on work effort … neither gross income nor hours worked increased.