Estonia`s Flat Tax Experiment

(Estonia has been having success with a flat tax. This from ``What We Know`` e-zine, thanks to my brother Brian for passing this along):




A Flat-Out Success

In America, the flat tax is a joke. So much so that an obscure TV journalist named Bernard Goldberg could launch a best-selling book career with Bias , in which the centerpiece story (told and re-told) is about how one of his CBS colleagues poked some on-air fun at Steve Forbes, the last serious presidential candidate to make a flat tax part of his platform.

In Estonia, however, Goldberg would probably have to find a different second career.

It's likely that most Americans couldn't locate Estonia-one of the former Soviet Baltic satellites-on a map. Yet what happened there has caught the attention of Europe and is beginning to pique a little interest here as well.

Estonia, when it finally cast off its Soviet chains, was as impoverished as any of the Republics. That was fourteen years ago, when the people elected Mart Laar as their prime minister. Laar was only 32, a scraggly-bearded history teacher who dressed in T-shirts and black chinos and loved to listen to Guns 'n Roses.

From the beginning, Laar thought outside the box-in part because he was unencumbered by previous political experience, in part because he'd only read a single book on economics in his life, and in part because he was young and idealistic in the first heady days of freedom. Today he's considered a prophet, and is consulted by politicians and economists from countries around the world. Excluding ours.

Under Laar's leadership, Estonia enacted a 26% flat tax on income in 1994. No loopholes, no exemptions. It also instituted 0% inheritance taxes and, to encourage reinvestment, no tax on corporate profits until they are distributed as dividends.

Last April-as Laar celebrated the 25th anniversary of Solidarity with Lech Walesa, and met with Cuban opposition leaders to plot out how to change their country after Fidel passes-he recalled the resistance he faced: "Most experts advised against it, and said it was a stupid idea. My finance minister said don't do it, the IMF said don't do it. But it's not very easy to convince a young person that he is wrong and I was that type of young person. So I did it."

Estonia was quite fortunate he was that type of young person. Inflation, then running at 1,000% per year, dropped to 2.5%. Unemployment plunged from 30% to 6%. As a flood of foreign investment buoyed the economy, growth reached double digits in 1997. Even after the worldwide slump of 2000, it leveled off at 6% per year.

Laar is a bit bemused by his canonization as the father of the flat tax. "My main 'problem' was I was not an economist but a historian," he says.

That one economics text he had read? Milton Friedman's Free to Choose . After reading it, he just assumed it represented mainstream Western thought, and that Friedman's theories were standard practice. He hardly expected to be hailed as a pioneer. It was just that "a flat tax seemed to be very logical and very fair," he says. "I didn't have the smallest clue I would be the first."

Laar explains the logic and simplicity of his system: "The same rate of tax for everybody, or no rate at all. There is a minimum level at which it kicks in. There's no point wasting state money collecting tax from the very poor... [and] rich people are paying significantly more tax even with the same percentage... It is [also] very efficient in destroying the black market, [being] very easy to collect and control." Overall, "In a highly progressive tax system there is no incentive to work: the harder you work, the sooner you get to the next, higher tax level. A flat tax generates more growth and therefore more revenue for the government."

The results seem to bear him out. General government revenues, 39.4% of GDP in 1993, were 39.6% in 2002. This has been sufficient to allow the tax to be lowered to 23%, with a further cut to 20% scheduled for next year.

Estonia's neighboring Republics, Latvia (25%) and Lithuania (33%), established their own flat taxes by 1995, and by 2005 most of eastern Europe had fallen in line, as Russia (13%), Serbia (14%), Ukraine (13%), Georgia (12%), and Romania (16%) followed suit. Slovakia went to a 19% flat rate in 2004 and, counter to the Estonian model, decided to encourage savings by taxing corporate profits (at the same 19%) but not dividends.

Russia's experience may be the most instructive. At the turn of the century, the government was bankrupt and had to do something. Its radical reorganization included a 2001 overhaul that consolidated 12%, 20% and 30% progressive tax bands into one 13% flat tax. The following year, there was a general economic rebound that saw a healthy 12% growth in wages. Yet government revenues jumped more than twice as much, by 26% (they went on to double by 2005).

Why the disparity? Laar and other flat-tax advocates would say that disincentives to work had been removed. Maybe. But a study authored by Anna Ivanova and Michael Keen of the IMF, along with Alexander Klemm of London's Institute of Fiscal Studies, argues otherwise. These economists found little evidence that Russians were working harder, which is unsurprising since those who had previously inhabited the 12% bracket were actually paying more in taxes. What they did find is that the former members of the two higher brackets reported 68% of their income in 2001, under the flat tax, vs. only 52% the year before.

This suggests that the flat tax's primary attraction might be that it simplifies, something to keep in mind when considering the situation in the U.S. In a typical year, the IRS estimates that for every dollar it collects, about 20 cents is owed but not paid. The Economist addressed that issue in a recent article: "In part, the tax system is burdensome because people dodge it. Every loophole that is exploited must be plugged. Every blurry line that is crossed must be sharpened. But Messrs [Jeffrey] Owens and [Stuart] Hamilton [of the Organisation for Economic Co-operation and Development] worry that the tax-codifiers and the tax-dodgers are locked in a mutually destructive 'arms race'. The code is made more complex, because of tax wheezes. More people then seek to avoid taxes. The best way to fight tax avoidance, then, is with simplicity."

As the highly taxed citizens of Western Europe grow increasingly restive, their systems have come under examination as well. Because it's such an explosive issue in a union of welfare states, the flat tax is probably not coming anytime soon. Nevertheless, France and Spain are reducing the number of brackets and lowering their top rates; Greece is poised to adopt similar changes; Britain's Conservative Party has a commission studying flat taxation; and Angela Merkel, vying to become Germany's next chancellor, has a flat-tax advocate as one of her top economic advisors.

The bottom line isn't fairness, it's competitiveness, says Paul Mylonas, chief economist at the National Bank of Greece. "Our neighboring countries are reducing taxes, which provides them with a more attractive business climate."

Not everyone is sold on the idea, of course. Critics question how much of Estonia's robust revenues are due to the flat tax, since it still levies an 18% VAT on most sales, and collects a hefty social security/pension/health insurance tax. Each of these contributes more to general revenues than the income tax.

But such criticisms don't attack the fundamentals. Almost no one-short of those philosophically wedded to soak-the-rich progressive taxation-is suggesting that a flat income tax would be worse than one that relies on more than 60,000 pages of code (up 50% in just the past ten years) and a vast, universally despised enforcement bureaucracy. The IRS now has 115,000 employees, more than EPA, OSHA, FBI, DEA, FDA, and BATF combined. It seems tax reform is clearly something that should be put to a full debate here at home.