The Flat Tax for Developing Countries

March 19, 2006 • Commentary

One of the most important public policy debates in many Western countries today (including the US, Germany, and the UK) concerns the introduction of a flat tax to replace their immensely complicated and highly distorted systems of taxation. This debate is best seen as part of the development of a post‐​Keynesian consensus on the conduct of economic policy. It is worth examining this case in this wider context and showing why it may be of relevance to developing countries such as India.

There seems to be widespread public policy consensus that activist monetary policy based on some version of Keynesianism is counter‐​productive. This is largely because its effects are subject to long and unpredictable lags and its potential for being misused by politicians of every hue to further their own personal interests during the political business cycle. There is also considerable evidence that the private sector will damp any unavoidable fluctuations in economic activity and stabilize the economy if it is not disturbed by unanticipated policy impulses. So there is growing agreement that the best way to conduct monetary policy is to leave it to an independent central bank which follows rules rather than discretion. These rules may be adaptive, not fixed, and can adjust in a predictable way to permanent changes in real growth or financial intermediation. This essentially depoliticizes monetary policy. Though not formally independent, the Reserve Bank of India in its recent actions has largely followed these prescriptions.

This leaves fiscal policy. The activist case for Keynesian fiscal policy was undermined even before that for its monetary cousin, as it was shown to be an even blunter and more inflexible instrument than monetary policy. This has led to the assignment of fiscal policy to deal not with the macro but the micro economy. As the case for using fiscal policy (of which tariff policy forms a part) to provide various incentives for “infant industries” or correcting other purported market failures has been undermined, in part because of the politically mediated costs of “rent seeking,” there is growing recognition that the sole aim of fiscal policy should be to provide finance for the optimal provision of public goods, at the lowest cost in terms of economic welfare. The distributive aims of fiscal policy have been equally undermined by the overwhelming evidence from around the world that, redistributive taxation has merely served as a vast churning machine in which the redistribution (at least in democratic polities) usually ends up benefiting not the intended beneficiaries but the middle classes, as all political parties seek to placate the median voter.

The technocratic answer to the problem of financing public expenditure on public goods, at least economic cost, was given by public economics. This is the system of taxes recommended by Frank Ramsey (Keynes’ young Cambridge colleague). It involves the taxing of goods with the most inelastic demand most heavily. Any tax (which is not lump sum, like a poll tax) involves a loss of what economists call “consumer surplus.” This loss will be greater for any given tax rate, the more elastic the demand curve (the more sensitive consumers are to price in the quantity of the good they buy). For, the rise in the price facing a consumer from the tax will lead to a larger reduction in quantity purchased than if demand were more inelastic. Hence the Ramsey Rule for optimal taxation.

But, this rule assumes that the government is benevolent. Suppose instead it is predatory, and not merely interested in raising a given revenue but in maximizing it, at least cost. What taxes would it choose? As Geoffrey Brenann and James Buchanan showed, it would choose Ramsey taxes! This has led to a search for a system of taxation which limits the ubiquitous fiscal predatoriness of governments. The flat tax, first advocated by Robert Hall and Alvin Rabushka, is the answer.

In its pure version a flat tax replaces multiple marginal tax rates with a single marginal tax rate, and abolishes the complex systems of allowances and reliefs, which governments use for social engineering, or for buying votes. A high personal tax‐​free allowance allows the poor to be taken out of the tax net and imparts progressivity to the system. All taxes—corporate, personal income, and commodity taxes (e.g. VAT)—are set at the same rate, amounting in effect to a consumption tax which abolishes any double taxation such as taxation of dividends.

The advantages of a flat tax are its simplicity and transparency (as Steve Forbes notes, everyone needs just a postcard for their tax return), leading to faster economic growth, due to greater incentives to work, and the removal of various disincentives and distortions caused by existing tax distortions, including the creation of large black markets through tax avoidance and evasion. These advantages have been apparent in the many East European countries (including Russia, Estonia, Latvia, Ukraine, Georgia, and Romania), which, whilst moving from the plan to the market, have adopted flat taxes, and induced consideration of flat taxes in others (Poland, the Czech Republic, and Slovenia).

But, unlike the new East European tax systems, which were replacing a defunct ancien regime, in most developed countries with mature tax systems which are the result of the past political (zero sum) redistributive game over many generations, the most likely losers from a flat tax are likely to be the past beneficiaries—the middle classes—who will use the democratic process to resist it. The back tracking on the proposal in the US, Germany and probably in the UK suggests a full‐​blooded flat tax, may be infeasible in these mature tax systems. Thus, the future of the flat tax number might lie in countries which, like the East Europeans, are moving from the plan to the market. The Chinese are said to be considering its adoption. If the Kelkar Commission’s tax reform recommendations were fully adopted in India, it would only be a small step to move to a full‐​scale system of flat taxes in India. This would curb the traditional fiscal predation of the state and its associated ills like the black economy, and have a favorable impact on the country’s growth rate.

About the Author