Real Tax Reform

Sunday, January 30, 2005
Will we ever get real tax reform in the United States? For several decades, economists, journalists, and politicians have been discussing the pros and cons of the flat tax, sales tax, value-added tax, and other proposals as alternatives to our current federal income tax. One commission after another has made recommendations to overhaul the federal income tax, but little has come of these efforts. Special interest groups and partisan politics have blocked all efforts at reform since 1986. Every year Congress further complicates the tax code. President Bush established another commission, his Advisory Panel on Federal Income Tax Reform, on January 7, 2005, but it will doubtless encounter the same obstacles. A new commission is not needed. A better approach is simply to look around the world at a raft of success stories. The flat tax has been adopted in eight newly independent Central and Eastern European countries, has been proposed by political parties in two more, and is even under consideration in China.
Estonia was first, implementing a 26 percent flat tax in 1994. The relatively high rate was set to balance its budget, a requirement of its new constitution. Since then, buoyed by strong economic performance, Estonia has eliminated the corporate tax on retained earnings, taxing only distributed profits. The rate is scheduled to fall to 24 percent in 2005 and 20 percent in 2007.
Next to follow in 1995 was Latvia with a 25 percent rate.
Russia is the big story. It took the tax reform world by storm in 2000 with a 13 percent flat tax, replacing its previous three-bracket system that topped out at 30 percent. The results have been spectacular. The economy has enjoyed four years of sustained growth. Real (inflation-adjusted) ruble revenue from the personal income tax rose 25.2 percent in 2001, 24.6 percent in 2002, 15.2 percent in 2003, and 16 percent in the first half of 2004. By year’s end, total receipts will have more than doubled; the share of consolidated budget revenue received from the personal income tax increased from 12.1 percent in 2000 to 17 percent at the end of 2003.
After a pause of three years, the flat tax resumed course. In 2003 Serbia implemented a comprehensive 14 percent flat tax on personal and corporate income.
Taking a page from Russia’s playbook, Ukraine implemented a 13 percent flat tax in 2004, replacing five brackets of 10, 15, 20, 30, and 40 percent. Dividends and interest on bank deposits will be taxed at an even lower 5 percent rate beginning in 2005. News reports suggest that Ukrainian officials consulted with their Russian colleagues. The advice they received was that incentives and revenue would rise and that the underground economy and tax evasion would decline.
In 2004 Slovakia implemented a 19 percent flat tax on both individual and corporate income. The measure, which passed by a vote of 85 to 48, garnered the support of some opposition deputies. The 19 percent flat tax replaced five brackets of 10, 20, 25, 35, and 38 percent and the corporate rate of 25 percent. It greatly simplified the previous system, which included 90 exceptions, 19 sources of income that were not taxed, 66 items that were tax-exempt, and 27 items with their own specific tax rates (e.g., bank interest, honoraria, etc.). Once the corporate tax is paid, dividends received by individuals are tax-free.
Georgia’s new president, Mikhail Saakashvili, was inaugurated on January 25, 2004. Five days later he stated that one of his new government’s top priorities was the introduction of a flat-rate tax system. On December 22, 2004, Georgia’s parliament approved the 12 percent flat tax effective January 1, 2005, by an overwhelming vote of 1,071 to 11. Seven days later, on December 29, 2004, the newly elected government of Romania implemented a 16 percent flat tax on personal and business income, effective January 1, 2005. Opposition political parties in the Czech Republic and Poland have proposed a 15 percent flat tax on both personal and corporate income.
In every case, a simple flat tax replaced complicated tax regimes with multiple rates.
In November 2003 I was invited by the Ministry of Finance to Beijing to discuss personal income tax reform. A Chinese translation of The Flat Tax was published in May 2003 by the China Financial & Economic Publishing House, with the preface written by Vice-Minister of Finance Lou Jiwei. During the past few years, several Chinese professors of public finance have written articles on the economic and fiscal benefits of sharply reducing China’s top personal income tax rate of 45 percent, some suggesting a flat 20 percent rate. The government is likely to announce some preliminary reforms of the personal income tax in its March 2005 budget.
Better than another tax commission would be a road trip to Central and Eastern Europe to see firsthand the success of the flat tax.