Bumpy ride for flat tax

Replacing today’s convoluted tax systems with a simple, single rate of tax paid by rich and poor alike on their earnings – flat tax – would be a banker’s dream and a politician’s nightmare. Politicians aspire to mould society into a new shape that reflects their own vision of paradise on earth and bequeaths them an impressive historical legacy. The tax system in a mature economy is a gift for performing all kinds of social manipulations and feats of engineering. Politicians see it as the ideal apparatus to bring their manifesto commitments to life while ignoring any perversities they may introduce in the process. It’s just too tempting not to tinker.
Loss of power
To give it up would take governments one more step nearer to a political castration that has already been engendered by a loss of power from globalisation, devolution where it has occurred and, in Europe, the rise of the European Union as a quasi-federal body. They are bound to resist it.
The commercial world sees things differently. In international business these days, merely operating has become an act of great complexity – never mind engaging in something as “radical” as entrepreneurship. The greatest challenge facing companies and banks is finding a way through the plethora of rules, edicts and general bureaucracy emanating from governments and their agencies. The cost of compliance is a massive drain on profits, while over-regulation is driving risk-taking activities out of the mainstream and into private equity firms and hedge funds.
Flat tax would not solve all these problems but it would be a major step towards making commercial life easier in the areas of investment and accounting. With a single tax rate levied on earnings (corporate and personal), every kind of deduction, credit or other distortion would be done away with at a stroke, and tax returns could be written out on a postcard – or so the flat taxers’ assert.
They also argue that with flat tax, total tax revenues increase because under a less onerous system higher earners opt to pay their taxes rather than indulge in sophisticated avoidance schemes. In addition, flat taxers argue, simple and lower tax rates make work and investment more worthwhile activities; hence overall economic activity increases and the tax take expands in step with this.
But where flat tax has caught on – mainly in emerging Europe – the tax base was so small and tax evasion so widespread that politicians had nothing to lose by adopting the system. Flat tax has not yet been introduced into an advanced economy where not only would politicians have to abandon their dreams of a paradise on earth, they also risk creating a fiscal gap as tax revenues from the old system are lost while the gains of flat tax take time to materialise and are of unpredictable quantity.
Does that mean flat tax is condemned to be an ‘ivory tower’ theory that academics can argue the logic of but politicians would never countenance? Not necessarily. Since The Banker’s foundation in 1926 some big and formerly unimaginable concepts have passed into conventional economic thinking. The theories of John Maynard Keynes (who used to write for The Banker) – on how full employment and economic growth could be managed through fiscal and monetary levers – rose to become the conventional wisdom and then fell into decline.
Rise and fall
Communism, in case anyone has forgotten, was such a potent ideology that until relatively recently most western European countries had a major communist or unreconstructed socialist party participating in the political process and advocating state ownership of production. In this era, mass privatisation as an economic concept was untenable but has now become the norm almost everywhere, regardless of political stripe. The rise of monetarism and indeed the perfecting of monetary “science”, along with central bank independence, provides another example of how ideas that are alien in one paradigm can quickly gain in stature and become the driving force of society in another. Will flat tax go down the same route?
Most accountancy professionals are sceptical that flat tax could ever be adopted in a pure form in an advanced economy. But they welcome the debate for raising issues about the shortcomings of current tax systems.
“Flat tax will founder politically because the transition to a new system involves losers, as a government removes tax benefits, and under a democratic system it’s unavoidable that politicians will want to incentivise different groups in return for votes,” says Patrick Mears, a partner with law firm Allen & Overy. “It’s a non-starter for major economies but it’s a good catalyst for thinking about the current tax system and asking serious questions about whether it’s too complex, whether compliance costs are too high, and why governments keep adding legislation but never take anything away.”
Says John Whiting, tax partner with accountants PricewaterhouseCoopers: “We will look back in 10 years’ time and we still won’t have a flat tax system [in western Europe and the US], whereas countries that currently have flat tax systems [emerging Europe] will probably have added complexities to theirs. But what I hope is that we have made some progress in simplification and in making the tax system more competitive.”
Academics, naturally enough, are more ideological. “Income tax is not only complex; it is perverse, diverting energy and resources into uneconomic behaviour forced upon people by the tax code itself,” says Andrei Grecu in Flat Tax: The British Case, published by the Adam Smith Institute. “In terms of growth forgone and effort misplaced, its economic costs reach into billions each year, maybe tens of billions. The time is long overdue for a radical simplification based on a single clear rate from which low earners are exempt. A flat tax in Britain would rapidly raise more revenue from a low rate, lift thousands from the low earner tax trap, and end the dubious double taxation levied on many types of income. It would set free creative entrepreneurial energy to create the jobs and the wealth needed to secure our future prosperity.”
The point about lifting thousands out of the poverty trap is an important one. Flat tax tends to be associated with right wing politics and its critics complain that it favours the rich who gain from lower tax rates. But flat tax systems that have more popular appeal can be established.
“Flat tax can still be progressive by setting the threshold at which tax starts to be paid quite high,” says Wouter Denhaam, professor of economics at London Business School. “In the current system, to get a true picture of the tax actually paid you have to look very closely at all the deductions [which may favour higher earners].”
Does this mean that flat tax could get itself on the mainstream political agenda? History shows us that tax is one of the most critical factors in the rise and fall of empires. Governments that have introduced arbitrary and unfair taxes have quickly been dismissed either by the ballot box or by violence, whichever was more appropriate to the circumstances. Similarly, governments that did not establish tax systems that effectively extracted sufficient resources to sustain them have also met an untimely end. The force that would push flat tax into policy would be if the current system became unworkable to such a degree that it put business at a competitive disadvantage. In that scenario, government revenues would be falling anyway and economic growth impeded. A tax revolution might be possible.
An ancient idea
Flat tax is, in any case, not a new idea. “Much of the evil in the income tax system comes from the direct confrontation between tax payer and the all mighty, self-righteous state,” writes Charles Adams in For Good and Evil: The Impact of Taxes on the Course of Civilisation. “If we had a flat collection at source of 10% for most people there would be no April 15, no confrontation between citizen and state, no intimidation. Only payers or those in business would have to file a tax return. Ten per cent is selected because this was the tax in the ancient world that operated for thousands of years, called the decuma. Not only was this the tax in the ancient world of Israel, Rome and Greece but it was also the rule for ancient China.”
But not all ancient civilisations escaped so lightly. In ancient Egypt they taxed everything they could, including sales, slaves, imports and exports. In agriculture they taxed land on the basis of what it should produce not what it actually produced and they sent inspectors into Egyptian kitchens to make sure that wives were not substituting cooking oil (which was taxed) with free drippings (which were not).
For long periods of time some countries have had relatively benign tax systems. The US, of course, was founded on the idea of escaping British taxes, and until the Great Depression of the 1930s taxes there were low and government spending accounted for about 3% of economic output. Since then wars and depression have led to huge rises in the tax take, which has risen to about 25% of gross domestic product (GDP) although still well below the Organisation for Economic Cooperation and Development (OECD) average of 36%. But while the US government’s tax hunger may be restrained compared with countries such as France and Germany, the complexity of its tax code knows no bounds.
Incomprehensible code
All flat tax advocates point to this absurdity. The architects of modern flat tax theory (see table below) are Robert Hall and Alvin Rabuska from the Hoover Institution, who wrote The Flat Tax. “The Internal Revenue Code consumes enormous quantities of ink and paper,” they say. “West Publishing Company, one of the official publishers of the federal tax code, published the 1994 code in two volumes. Volume one contains sections 1-1000 (1168 printed pages) and volume two, sections 1001-1564 (210 pages). The table of contents displays 205 separate headings. The code and regulations defy ready comprehension. A massive industry has grown up to service tax scholars, tax lawyers, tax planners, tax filers, tax accountants and even tax collectors.”
Steve Forbes, president and CEO of Forbes publishing house, who stood as a US presidential candidate in 1996 and 2000 on a flat tax ticket, points out more anomalies in his book Flat Tax Revolution. He quotes one part of the code, which describes how workers on oil rigs may or may not deduct meals from their tax depending on whether the rig is located in the US north or south of 54 degrees latitude. The editors of the US magazine Money gave 45 tax experts a return to fill out on behalf of a fictional US family and reported that they came back with 45 different answers, none of them correct.
Simplification is needed
The message is getting through. “We have lost sight of the fact that the fundamental purpose of the tax system is to raise revenues to fund government,” says the executive summary of November’s final report of president George Bush’s Advisory Panel on Federal Tax Reform. The panel proposes extensive simplification including reducing the number of tax brackets and reducing taxes on savings and investments but Chris Edwards, director of tax policy for the Cato Institute, has complained: “The plans do not include large enough cuts to top individual or corporate tax rates.”
In western Europe, interest in tax simplification and flat tax is being driven by one simple factor: competition. Nine east European countries now have flat tax systems including Estonia and Lithuania, which introduced the concept in 1994, and recent converts Romania and Georgia. The most surprising adoption was that of Russia, given the size of the country and its strong ideological past. In all countries tax receipts have gone up and there has been impressive growth but flat tax cannot reasonably take all the credit. The tax base in these emerging countries was minimal to begin with, evasion was widespread and high rates of growth and inward investment would have been expected as they caught up with western countries.
The other factor to look at is the impact of national insurance. Some flat tax countries have low tax rates but levy high rates of national insurance. National insurance can be tax under another name – as it is in the UK, where it does not guarantee any benefits – or it could be a funded social security system, in which case it is best regarded as forced savings rather than taxation. The latter idea would fit well with flat tax theory in that it is totally transparent as to where a taxpayer’s money goes and what it is for. Again, this may be unpopular with politicians, who like to allocate revenues to their own pet projects.
But as eastern Europe becomes a serious competitive threat to western European economies, the latter’s rulers may have to give up some of their high-mindedness. “The UK still receives huge inward investment and the government argues that the fiscal side is not a strong driver,” says Aidan O’Carroll, national head of tax at Ernst & Young in London. “But we are increasingly seeing multinational companies looking at the tax situation in the UK and concluding that it is a less attractive location to do business in, especially with all the recent emphasis on anti-avoidance.”
European interest
Interest in flat tax or tax simplification has been expressed by senior leaders in Spain, Germany and by the opposition Conservative Party in the UK. Many point to the case of Ireland, where the slashing of corporation tax drove a boom in inward investment. But if tax reform consists merely of reducing corporation tax it won’t be much of a revolution. Corporation tax is typically a low percentage contributor to a country’s overall tax receipts. The big money comes from income, social security and consumption taxes.
In any case, national and regional governments are already engaged in a competitive bid for investment that involves them giving such generous concessions that some accountants have dubbed it “the avoidance within” – Ernst & Young’s Mr O’Carroll recalls being hired by a government agency to instruct a potential investor on how best to reduce its tax liabilities.
So flat tax competition may push western Europe a small way towards flat tax but the impact would be limited. Another driver (surprisingly, given its own hunger for revenues) is the EU. It is seeking tax harmonisation and to this end has the backing of multinational corporations, which despair of having to deal with expensive tax accountancy in every country in which they invest. They are currently flexing their muscles by taking national governments to the European Court of Justice if they deem them in breach of European law.
The highest profile case has been that of UK retailer Marks & Spencer (M&S), which won its case in December to offset losses from European subsidiaries against UK group profits as it could if the business had been established in the UK. The British government argued that this would lead to a trafficking in losses. Certainly it will cause a huge loss of revenue. But under the EC Treaty Article 43 – freedom of establishment – M&S argued that the UK rules make establishing a subsidiary in another EU country less attractive than in the UK. Many other such rulings have gone in favour of companies and collectively they could lead to a more harmonised European tax system.
Profound change
Harmonised doesn’t necessarily mean flat, however, and for that to happen something much more profound must take place. Remember how the adoption of monetarism came about? In lifting economies out of recession in the post-war period, Keynesian demand management policies had proved highly effective. “We are all Keynesians now,” was how US president Richard Nixon referred to his administration’s management. Then the policies ran into serious problems with the arrival of high rates of inflation. After a while it became evident that government spending and monetary measures to raise economic demand were not producing growth, only inflation. Hence the term ‘stagflation’ was coined.
The uptake of monetarism grew out of these conditions whereby the controlling of inflation through interest rates and the money supply became the overriding economic policy that sensible governments everywhere were not permitted to tamper with. Since politicians accepted in this case their subordinate role, many were prepared to give up their powers (and, of course, release themselves from domestic pressures) and hand them over to independent central banks.
Sparked by crisis
If this transformation can take place in monetary policy why shouldn’t there be the same outcome in fiscal policy? Of course, it would take a crisis to bring it off, as it did with monetary policy, but the origins are not hard to imagine in the current environment.
Governments are cutting headline taxes for competitive reasons, are under pressure from the EU and the IMF to balance budgets and face massive pension liabilities and health costs. A fiscal crisis is more than likely and the outcome could be an independent fiscal authority to sit alongside the central bank. Almost certainly it would begin by recommending some sort of system of flat tax.
FLAT  TAX EXPLAINED
The theory behind flat tax is the Laffer curve. This suggests that there is an optimum point at which the government collects a maximum amount of tax. If it tries to raise the rate above that point, tax returns go down as people try to avoid paying tax or work less.

In the version of flat tax perfected by Robert Hall and Alvin Rabushka of the Hoover Institution the aim is to move towards a more consumption-based tax so called because of exemptions it provides for savers and investors. A single tax rate is applied to all income whatever its form, either corporate profits or personal incomes, and all earnings are taxed once only.

Under most current systems, income is often taxed twice, once when it is earned and again when it is either saved or invested. This discourages saving and investment.

While the threshold at which individuals start paying tax can be set relatively high to exclude many from paying tax altogether, all other kinds of deductions and tax credits disappear. The simplicity of the system can be seen from the following example: since all taxpayers are paying at the same rate, income tax could be collected direct from companies in a lump sum, making tax collection vastly easier.