The ups and downs of flatter taxes
There is no clear consensus on what is the ideal personal income tax. Could flat taxes be the way forward? The answer is not that simple.
Director, OECD Centre for Tax Policy and Administration
Imagine a tax return no longer than a postcard. This at least is what proponents of a “flat tax” system predict.
Filing is simplified, since gone are most deductions and exemptions. A flat tax improves the transparency of the income tax, cuts the administrative and compliance costs and, if the rate is low, reduces the temptation to evade tax. It even stimulates growth, its defenders claim. But there is a price: a move to a flat tax system strongly affects income distribution. Advocates of the flat tax say it has already proven its worth in Russia and other economies in transition, such as the Slovak Republic. The idea has now caught the attention of some OECD countries, including Italy, Greece and Mexico.While no government has implemented a pure flat tax, politicians in many OECD countries have recognised the need to reform their personal income tax system over the last two decades. Paired against mounting expenditures brought on by ageing populations, healthcare and other social needs, a broader tax base can shore up tax revenues. But governments must also make taxes competitive in order to lure investors and prevent the decampment of their own businesses and workers. Yet no clear consensus has emerged on what is the ideal personal income tax. Could flat taxes be the way forward?A flat tax system is generally understood to mean a single positive marginal tax rate for personal income, set relatively low. In such a system, capital and labour income is taxed at the same rate for everyone, rich or poor, as the rate schedule is reduced to a single rate.Unlike a “progressive” system, earning more does not mean being subject to a higher tax rate. Although most deductions and exemptions are eliminated, a standard tax threshold is given to all taxpayers, above which they start paying tax.In theory, a low rate flat tax creates incentives to work, to save and invest, to become an entrepreneur and to take risks. In addition, the flat tax system’s simplicity may encourage people to comply with the tax rules. Moreover, proponents say it helps the poorly educated or elderly who are often baffled by the complexity of tax forms or are ignorant of the exemptions to which they are entitled.The crucial question is whether flat tax systems fairly distribute the tax burden. Depending on the flat tax rate and basic allowance, flat tax reform most likely implies that high-income earners gain at the expense of middle-income earners who will have to pay a higher tax rate. Whether low-income earners will benefit from a flat tax reform depends on the size of the basic allowance.Most OECD countries run along the tracks of either a “comprehensive” or “dual” personal income tax system, with variations on both. Comprehensive systems include all sources of income in the same tax base and levy progressive rates, usually with generous allowances and exemptions. They are founded on the principle of both vertical and horizontal equity: taxpayers at the same income level are taxed equally, and taxpayers at a higher level of income are taxed more as a proportion of their income. The advantage of these systems is that they limit income shifting, a practice in which higher-taxed labour income is transformed into lower-taxed capital income. Their weakness lies in the reduced efficiency as a result of the often high and progressive rates and in the high compliance and administrative costs. At present, no OECD country has a purely comprehensive system, since all countries with these systems have special tax treatment for fringe benefits, capital gains, owner-occupied housing, pensions and so on.Taking the alternative road, Scandinavian countries and the Netherlands opt for a dual approach, levying a progressive tax on labour income, but a proportional tax on capital income. This lower tax on capital income recognises that capital income is more mobile than wage income.One weakness of this approach is that the effective tax levied on total income will depend on the relative amounts of capital and labour income earned. This might undermine the tax code’s vertical equity, especially because income from capital tends to be concentrated in the upper income brackets. And, of course, in the dual system, there is an incentive to shift highly-taxed labour income into lower-taxed capital income.So, what of the flat tax? Academics, in the US and elsewhere, have been debating the question for a quarter century, but it was Russia that became the first major country to adopt one when it imposed a flat tax rate on income, of 13% in January 2001. Over the next year, personal revenue jumped by 26% in real terms, and as a percentage of Russia’s GDP, incomes increased by a fifth.Small wonder that other countries in the Eastern bloc, hoping to jump-start their transition economies, followed suit: Ukraine, the Slovak Republic, Georgia and Romania joined Estonia, Lithuania, Latvia and Russia in implementing a flat tax.Nevertheless, the linkage between a shift to a flat tax system, revenue yield and economic growth is ambiguous. Whether Russia’s economic fortunes can be attributed to the adoption of a flat tax is not so clear. Russia’s GDP grew by 4.6% in the first six quarters following the adoption of the flat tax, whereas in the preceding six quarters, it grew more than twice as much at an annual rate of 10.6%. The government had already undertaken vigorous tax reforms, aimed primarily at curbing evasive practices among Russia’s wealthiest. In 2001, just from reining in tax evaders, tax authorities remitted double the amount they had a year earlier. In fact, as a paper in Economic Policy suggests, it appears that greater transparency, ease of compliance, and enforcement of tax laws exerted a bigger influence than did the actual change in income tax rates (see references).
But while the Russian reforms tackled an inept and corrupt tax system, revenues also rose to reflect a surge in the price of oil (Russia’s most important export commodity), which nearly quadrupled between 1999 and 2000, as well as an 18% increase in real wages in 2001. Moreover, the personal income tax reform, with marginal rates of 30, 20, and 12% replaced by a flat 13% tax rate, only benefited the top two tiers; the poorest taxpayers experienced a small increase in tax rate. But compared to its neighbours, Russia’s poor may have got off lightly. In seven out of eight countries, the poorest wage earners paid up to 25% more on their income, although this increase was buffered by more generous allowances. As for the argument that cutting tax rates increases labour supply, the figures are inconclusive. Labour supply in Russia did not change in any of the groups, despite the dramatic reduction of rates. On the other hand, compliance improved.Judging how much a flat tax contributed to the successes of Russia and Eastern Europe is difficult. Moreover, neither Russia nor the Slovak Republic has implemented a genuine “flat” tax system. For instance, both countries continue to levy social security contributions separately. The use of social security contributions means that there continues to be gains from income shifting between capital and labour income, even under a flat personal income tax system.It is also hard to say whether flat taxes can adequately address one of the biggest challenges posed by a global economy: maintaining a strong tax base in a world of increasingly mobile capital. Given the government’s revenue needs, having a flat tax on capital and labour income might require a rather high tax rate, which might raise problems because of the international mobility of tax bases. On the other hand, implementing a rather low flat tax rate would undermine the benefit system in many OECD countries and would adversely affect income redistribution.Though no OECD country has adopted any of the comprehensive, dual or flat systems fully, the trend appears to be for flattening. How far governments will tread along this path is an open question. Taxes may be getting flatter, but there are still mountains to climb.
- Gaddy, Clifford G, William G. Gale. (2005), “Demythologizing the Russian Flat Tax”, Tax Notes International, 14 March.
- Ivanova, Anna, Michael Keen and Alexander Klemm (2005), “The Russian ‘Flat Tax’ Reform”, Economic Policy Vol. 20, No. 43.
- Keen Michael, Yitae Kim and Ricardo Varsano (2006), “The ‘Flat Tax(es)’: Principles and Evidence”, International Monetary Fund Working Paper No. 06/218.
- OECD (2006), “Fundamental Reform of Personal Income Tax”, OECD Tax Policy Studies No. 13.
- Visit the Centre for Tax Policy website
©OECD Observer No. 261 May 2007