Thursday, December 14, 2017

Flat-Rate Taxation History Tells Us Only Progressive Taxation Works

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!’”

The interested reader might find the following articles informative:

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