Commentary

Iceland Comes in From the Cold With Flat Tax Revolution

Listen up, Gordon Brown and George Osborne. Iceland has joined a growing list of nations that have sharply cut their corporate tax rates and adopted flat-rate individual income taxes, with hugely positive consequences on economic performance. With the expiration of a surtax last year, individuals now pay a flat rate of 22.75% of their taxable income to the central government.

Granted, Iceland’s system is not a pure, academic flat tax. Local governments also tax income at a single rate, pushing the combined flat rate up to 36%. Not only is the rate high, but Iceland also retains some double taxation of saving and investment, as well as a few special tax preferences.

Compared with other developed nations, however, Iceland has moved dramatically in the direction of a tax system that collects a given amount of revenue in a way that minimises economic distortions.

The reduction in the top tax rates was introduced to cut penalties on productive activities. As recently as 10 years ago, Iceland’s central government imposed a top individual tax rate of 35.41%, comprised of a general tax rate of 30.41% and a surtax on higher incomes of 5%. Combined with local income taxes of almost 12%, the government was taking nearly half of additional income earned by Iceland’s most productive taxpayers.

Under recent reforms, the central government’s general income tax rate has fallen by more than seven percentage points and the surtax eliminated. With the addition of the local income tax, which has increased slightly, the combined top tax rate is now 36%.

As is the case in almost every flat tax country, Iceland’s system has a substantial tax-free threshold. Taxpayers get a credit of about $5,000 (£2,551, E3,759) per adult and $2,000 per child. In addition, there are tax preferences for housing and seafarers.

Iceland has a relatively modest payroll tax of about 6%, technically paid by the employer. Almost all workers in Iceland have employer-based pensions based on private savings. Iceland also has an onerous value-added tax with rates between 14% and 24.5%.

The corporate income tax rate is 18%, among the lowest in the industrial world; it has been cut steadily from 50% in the late 1980s, to 33% by the mid-1990s, and to just 18% by 2002. The rate cuts have created a powerful increase in investment incentives and boosted economic growth. Rather than creating a revenue loss for the government, Iceland’s corporate tax cuts have coincided with rapidly rising corporate tax revenues, a traditional Laffer curve effect.

In the decade to 2001, which saw the company tax rate lowered slowly to 18%, corporation tax revenues tripled from about 3bn kronas to 9.1bn kronas ($134m). Since 2001, corporation tax revenues have tripled again to stand at an estimated 33bn kronas last year, significantly higher as a share of GDP.

In addition to the flat tax for individuals and dramatic corporate tax rate reductions, Iceland has made other reforms. It reduced its estate tax rate to 5%, implemented a flat tax of just 10% on capital income, repealed a turnover tax on business, and abolished a wealth tax.

Another economic reform was the creation of private property rights for fisheries, a policy that is being adopted by other nations.

Another economic reform was the creation of private property rights for fisheries, a policy that is being adopted by other nations.

Iceland also granted independence to its central bank to create a stable monetary policy, and it has privatised numerous businesses.

All these reforms have helped Iceland climb from 26th to ninth in the “Economic Freedom of the World” rankings since 1990. According to the World Bank, Iceland is now one of the world’s richest nations, ranking in the top 10 using either of two different methodologies. Unemployment in Iceland is almost non-existent, dropping to less than 2% in 2006, according to the International Monetary Fund.

The Organisation for Economic Cooperation and Development also has a positive report. It notes: “Iceland’s economy and per capita income have grown at an impressive pace since the mid-1990s, making the country one of the most prosperous in the OECD.” In particular, Iceland’s “real GDP has grown by 4% per annum, significantly bettering OECD growth over that period making the country the fifth-wealthiest in the OECD”.

Although Hong Kong, Jersey, and Guernsey have operated successful flat tax systems for decades, the modern flat tax revolution began with Estonia in 1994. Latvia and Lithuania quickly joined the flat tax club, followed by Russia in 2001. Ukraine, Slovakia, Romania and Georgia were part of the second wave of flat tax nations.

The club of 13 flat tax nations also includes Mongolia, Macedonia, and Kyrgyzstan. And because of tax competition, it is likely that more nations will join the club.

Iceland’s flat tax rate remains high. Other reforms, particularly the low corporate rate and the 10% tax on capital income, are more dramatic. From a political perspective, however, the Iceland reform is remarkable. It is the first time a western nation chooses no longer to impose discriminatory tax rates on successful taxpayers.

Tax reform and economic liberalisation have helped Iceland prosper. Let’s hope that other industrial nations – and especially Brown and Osborne – will learn from Iceland’s success.

Dan Mitchell is a senior fellow at the Cato Institute.