Most of the former communist countries of Eastern and Central Europe have instituted flat‐rate income tax systems. Estonia was the first, and Bulgaria is one of the most recent, having only moved to the 10 percent flat rate at the beginning of this year. The flat rate for Bulgaria was first proposed by exceptionally talented young economists affiliated with the Institute for Market Economics (IME), the country’s leading free‐market think tank.
Economists in the Finance Ministry claimed that such a drastic cut in the top income tax rates would cause tax revenue losses, resulting in a large budget deficit. However, the opposite occurred, just as IME economists had predicted.
The problem was that the economists who were then in the Finance Ministry were still using old‐fashioned, static revenue models that did not capture the behavioral effects of such a tax change. Unfortunately, the tax revenue models still in use in the United States by Congress and even many private organizations are largely static rather than dynamic models, and therefore incorrectly project tax changes.
If Sen. Barack Obama’s economists would run their proposed tax increases on small businesses, upper‐income individuals, and capital gains through a proper and full dynamic model, they would find that the projected revenue gains from these tax rate increases would be largely nonexistent. If Sen. John McCain’s economists would run their proposed tax rate cuts through, again, a full dynamic model, they would find they should be cutting tax rates even further for the U.S. economy to reach its full potential.
The income tax rate cut in Bulgaria caused its economy to grow more rapidly, and hence there was a surge in the VAT (value‐added tax) and other consumption tax revenues, as well as a reduction in the underground economy. This year, the Bulgarian economy will grow about 4 times faster than the average of the European Union (of which Bulgaria is a member). Given the success of the flat tax, many who initially opposed it now claim to have supported it all along.
Bulgaria privatized its banks, did not create semi‐socialist mortgage banks like Fannie Mae and Freddie Mac, has required banks to keep adequate reserves (which now average 13 percent, about double the U.S. average), and now is in a much better position to weather the international financial crisis.