Commentary

Flat World, Flat Taxes

From Montenegro to Mauritius, competition is making tax codes simpler and fairer.

Fifteen years ago, advocates of the flat tax had lots of supporting theory, but very little firm data. Milton Friedman had championed the flat tax, and Alvin Rabushka and Robert Hall of the Hoover Institution authored an elegant book detailing how a flat tax would work, but the political establishment largely ignored these efforts. Hong Kong had a flat tax, but critics said it was somehow a special case. Two other British territories, Jersey and Guernsey, also had flat tax systems, but the outside world was (and largely still is) unaware of those systems.

The world has changed. Today, spurred by tax competition, there are now 16 jurisdictions that have some form of flat tax, and two more nations are about to join the club. With the exception of Iceland and Mauritius, all of the new flat tax nations are former Soviet Republics or former Soviet Bloc nations. This is a sign of tax competition in the region, and shows that people who suffered under communism are less susceptible to class-warfare rhetoric about “taxing the rich.”

Flat Tax Jurisdictions Year of Enactment Tax Rate
Jersey  1940  20%
Hong Kong  1947  16%
Guernsey  1960  20%
Estonia*  1994  22%
Latvia  1995  25%
Lithuania**  1996  27%
Russia  2001  13%
Serbia  2003  14%
Slovakia  2004  19%
Ukraine***  2004  15%
Romania  2005  16%
Georgia  2005  12%
Iceland  2007  35.7%
Mongolia  2007  10%
Kyrgyzstan  2007  10%
Macedonia  2007  12%
     
Future Flat Tax Jurisdictions Goes Into Effect Tax Rate
Montenegro  2007 (July)
 15%
Mauritius  2009  15%
     
Active Consideration Target Date Proposed Rate
Albania  2008  10%
Czech Republic  2008  15%
East Timor  2008?  5-10%
     
* Originally 26%  
** Originally 33%  
*** Originally 13%  

By the time readers are done with this article, the flat tax list may get even longer. As indicated in the table, three nations are actively pursuing tax reform. Prospects look very good in Albania and East Timor (where even the IMF is on board, though the international bureaucracy predictably is pushing for a higher tax rate), while there is a more challenging situation in the Czech Republic because the government does not have an absolute majority in Parliament. These findings put the lie to an IMF study from last year that claimed: “Looking forward, the question is not so much whether more countries will adopt a flat tax as whether those that have will move away from it.”

Almost all of the new flat tax nations are former members of the Soviet Union. This shows that people who suffered under communism are less susceptible to class-warfare rhetoric about “taxing the rich.”Yet not only are nations rushing to join the flat tax club, but not a single nation has adopted a flat tax and then gone back to the old system of discriminatory rates. Even in Slovakia, where a socialist/nationalist government came to power last year, the flat tax has been preserved. Even anti-market politicians realize that it is not wise to kill (or chase away) the geese that lay golden eggs.

Not only are more countries adopting the flat tax, but those with flat taxes are now competing to lower their rates. Estonia’s rate already is down to 22 percent, and will drop to 20 percent in 2009. But the rate may drop even sooner and by a deeper amount. The government elected earlier this year has pledged to drop the rate to 18 percent and the Prime Minister’s party wants the rate eventually to settle at 12 percent. Lithuania’s flat rate also has fallen from 33 percent to 27 percent, and will fall to 24 percent next year. Macedonia’s rate is scheduled to drop to 10 percent next year, and Montenegro’s flat tax rate will fall to 9 percent in 2010—giving it the lowest flat tax rate in the world (though one could argue that places like the Cayman Islands, Bermuda, and the Bahamas have flat taxes with rates of zero).

It is appropriate to note that many of the world’s flat taxes are not completely consistent with the pure model created by Professors Hall and Rabushka. Nations such as Russia and Lithuania have substantial differences between the tax rates on personal and corporate income (and even Hong Kong has a small gap). Serbia’s flat tax only applies to labor income. Most, if not all nations, retain at least some double-taxation of income that is saved and invested (though Estonia, Slovakia, and Hong Kong get pretty close to an ideal system), and it does not appear that any nation permits immediate expensing of business investment expenditures.

But whatever the imperfections of any particular nation’s system, the flat tax revolution has brought with it several meaningful accomplishments:

  • Stronger incentives for productive behavior. Flat tax rates almost always mean a lower tax rate on work, saving, investment, risk-taking, and entrepreneurship.
  • Encouraging capital accumulation. As noted in the previous section, few if any flat tax systems live up to the Hall/Rabushka goal of eliminating all discriminatory taxes on income that is saved and invested. Yet most of the world’s flat tax systems have reduced the tax penalty on capital.
  • Evening out the tax burden. Some nations (like Slovakia, Estonia, and Hong Kong) have done a better job than others, but most every flat tax system includes a reduction in the special preferences that distort market decisions and cause economic inefficiency.

The growing community of flat tax nations shows that class warfare objections can be overcome. To be sure, globalization is probably the big factor since politicians increasingly understand that punitive tax regimes cause jobs and investment to flow to nations with better tax law. This suggests that the flat tax will spread around the world.

This is a pleasant scenario, but there are still significant hurdles. Most important, international bureaucracies are obstacles to tax reform, both because they often provide bad advice and because they specifically seek to thwart tax competition. The Organization for Economic Cooperation and Development (OECD), for instance, has a Harmful Tax Practices project (originally, and unwisely, labeled the “Harmful Tax Competition” project) that seeks to hinder the flow of labor and capital from high-tax nations to low-tax jurisdictions. The agency recognizes the importance of the issue for advocates of more government: in a 1998 report, it observed that tax competition “may hamper the application of progressive tax rates and the achievement of redistributive goals.”

The OECD effort has been widely—and appropriately—criticized for seeking to undermine fiscal sovereignty in order to prop up Europe’s uncompetitive high-tax welfare states, but it also should be seen as a direct attack on tax reform. The Paris-based bureaucracy’s anti-tax competition project is primarily focused on enabling high-tax nations to track—and tax—flight capital. This necessarily means that the OECD wants countries to double-tax income that is saved and invested, and to impose that bad policy on an extra-territorial basis. Flat tax nations are a direct threat to the global regime envisioned by the OECD since they would be “havens.”

In effect, there is a global contest being waged. On one side are pro-market forces that value tax competition as a powerful force for better tax policy. The global tax reform revolution is a symptom of how globalization is pushing policy in the right direction. On the other side, however, are international bureaucracies such as the OECD (the European Commission and United Nations also oppose tax competition). These bureaucracies are asserting the right to dictate what they refer to as “best practices” in a way that would control the types of tax policy a jurisdiction could adopt.

So far, thanks in part to the Center for Freedom and Prosperity, this effort to create a global tax cartel has been thwarted. Assuming political developments (especially in the United States) do not alter the balance of power in favor of Europe’s welfare states, tax competition will continue to thrive and an “OPEC for politicians” will never materialize. Iceland is the only “first world” nation to jump on the flat tax bandwagon thus far—but it may merely be a matter of time before tax competition brings good tax policy to the rest of Europe and even the United States.

Daniel Mitchell is a Senior Fellow at the Cato Institute.