Commentary

U.S. Could Learn from Mexico’s Flat Tax Experience

With the 2012 tax season finally over, Americans recognize the absurd complexity of the U.S. tax system more than ever.

Now’s an ideal opportunity to consider in earnest precisely how policymakers could go about reforming the tax code to make filing one’s taxes less of an annual torture.

There is certainly political will for such a move. A recent Rasmussen poll found that 61% of likely U.S. voters support the idea of getting rid of the existing income tax system and replacing it with something simpler.

One of the most popular reform ideas is the flat tax — a single, uniform rate applied to all income, without exemptions, deductions or special favors. The flat-tax approach could apply to individual income taxes as well as to taxes on businesses.

The flax tax is a bold and vital idea, which has caught on in many emerging markets.

Done right, it could revitalize the American economy.

But my home country of Mexico serves as a cautionary tale for what can go wrong when policymakers try to exploit the flat tax as just another instrument to further revenue collection.

In Mexico, the unhappy experience centered on business taxes. In January 2008, thanks in large part to the leadership of President Felipe Calderon, Mexico installed a national 16.5% flat tax — officially known as the IETU — on all corporate earnings. It was eventually adjusted upward to 17.5%, which is the current rate.

The problems plaguing the Mexican tax code that inspired the IETU effort are similar to those plaguing the American system. Mexico’s code was riddled with an absurd number of deductions and carve-outs for special interests.

Tax code complexity generates massive compliance costs that leave businesses with less money and labor to put toward genuinely productive activities.

In Mexico, code compliance expenses involve a transaction cost of almost 2% of gross domestic product.

The prevalence of these transaction costs are a big reason behind the drag on productivity growth, which also explains Mexico’s constant underperformance in economic growth — a mere 2.6% average annual growth rate in the past two decades — despite the major strides taken in areas like global trade integration, fiscal discipline and monetary stability.

Code Complexities

In the U.S., citizens spend over 6 billion hours a year filling out tax forms.

Research from the Laffer Center shows that for every dollar collected by the IRS, taxpayers incur an additional 30 cents in compliance costs, totaling $431 billion every year.

In Mexico as in America, large corporations have the resources and the perverse incentive to exploit complexities in the tax code to reduce their taxes.

In Mexico, while the official corporate marginal tax rate was 30%, many businesses routinely finagled their burden down to as low as 6% “effective” tax rate.

To get a sense of the size of that same problem in America, consider that General Electric paid precisely 0% in taxes on net income in 2009 and 2010.

Done right, the IETU would have transformed the Mexican economy, radically simplifying tax compliance and in the process getting rid of mountains of existing loopholes.

But something went wrong between conception and implementation.

By the time President Calderon obtained congressional approval, and signed the bill into law, it looked wildly different from the ambitious concept of the flat tax envisioned at the start of the administration.

Tax Tinkerers

Policymakers, obsessed only with tax revenues, started tinkering — then they tinkered and tinkered some more, to the point that the final law has made the country’s tax code far worse.

Instead of a simple, straightforward rate on earnings, businesses got handed yet another bundle of complexities in calculating and complying with tax obligations.

Indeed, the worst mutation by far was that instead of replacing the old, broken corporate income tax system, the IETU was introduced as an alternative to compete with it.

Every year, businesses have to tally up how much they owe under both the old corporate rate (with countless of deductions) and the flat tax alternative — then are supposed to pay the higher amount.

Shockingly, instead of using a simple idea to simplify economic life, the government managed to increase compliance costs.

Businesses have to hire double the lawyers and accountants every tax season, leaving even less time and money for productive activities, and making it all the more likely that they might decide to avoid paying taxes entirely.

Tax evasion today represents almost 40% of all (nonoil) tax revenues collected!

The IETU (some of my friends refer to it as the YETI, i.e., a real abomination) was conceived as a way of streamlining the tax code in order to spur business growth, especially in small and midsize concerns, and make Mexico more accommodating to investment.

But politicians morphed it into a brazen money grab.

The law that Calderon signed is nothing like what flat tax advocates were originally hoping for.

The law is now under congressional review. Not surprisingly, the consensus has grown to simply get rid of it. In the process, the very idea of a flat tax has unwittingly gotten a bad rap.

American policymakers need to avoid our mistakes. The U.S. tax code needs to be simplified. There could soon be the political will for installing a national, uniform flat rate.

When legislators go about writing that rate into law, though, they must keep it pure and simple — and fight against any special-interest scheming to re-create the costly and inefficient rules of the past.

Roberto Salinas-León is executive director of policy analysis in Mexico City and an adjunct scholar at the Cato Institute.