In its 2017 budget, Italy’s centre-left government enacted a new flat tax for Italian first-time residents. The flat tax amounts to euro 100,000 regardless of the amount of taxable income. If elected into power at next year’s general election, the centre-right coalition plans to replace the existing progressive tax system with a 15 percent flat rate.
The flat tax concept has come to the fore following the publication, in 1981, of an article in the Wall Street Journal by two economists from the Hoover Institution at Stanford University, Robert Hall and Alvin Rabushka. The economists put forward a tax reform plan for a 19 percent tax rate on both corporate and personal income in the United States. Hall and Rabushka contended that their proposal was “so simple that everyone could file their income taxes on a postcard and that a single rate of 19 percent, including a large personal exemption, would collect the same revenue as the existing income tax.”
The system of taxation that Hall and Rabushka propose has proved to be very popular in Eastern Europe in the aftermath of the collapse of the Soviet Union.
The newly independent countries of the former Soviet Union and Eastern Europe were amongst the most enthusiastic adopters of free market reforms. In the mid-1990s, not only they did embrace free market capitalism, but they also adopted bold and, to some extent, ground breaking policies like the flat tax regimes and private pension schemes.
In these countries, the flat tax system was mainly enacted in an effort to attract foreign investment.
After the collapse of the Berlin Wall, East European countries were hungry for capital and desperately needed investment to rebuild their economies. As the former Soviet Union countries competed with one another to attract foreign investors, offering the lowest tax rate possible became the key the key differentiator .
In 1994, Estonia became the first country in Europe to introduce a so-called flat tax, replacing three tax rates on personal income, and another on corporate profits, with one uniform rate of 26 percent.
Latvia and Lithuania promptly followed suit. In 2001, Russia too moved to a flat tax on personal income. Three years later, Slovakia imposed a uniform 19 percent rate on personal and corporate income, and set the same rate for its value-added tax (VAT) too.
Cutting tax rates decrease revenues and increase deficits
Hall and Rabushka claim that lower tax rates would generate more revenue through the so-called Laffer effect. The Laffer Curve is a theory developed by economist Arthur Laffer to show the relationship between tax rates and the amount of tax revenue collected by governments. In theory, when the tax rate is reduced through a flat tax, revenue grows since the lower rate drives taxpayers out of the shadow economy.
Despite its theoretical appeal, economic evidence suggests that the budgetary impact of the flat tax can be significant and sometimes even quite costly in the near term.
Most former communist nations witnessed unprecedented levels of economic growth following the introduction of the flat tax reform. However, in countries like Slovakia and Russia, the question still remains just how much new economic activity resulted directly from the single tax rate.
The Russian economy expanded at an average annual rate of 6.6 percent between 2001 and 2008 whilst government revenue increased from 27.1 percent to 33.7 percent of GDP during the same period, albeit most of the growth came from the country’s booming energy sector rather than from the effects of the 13 percent flat rate.
In the years that followed the 2008-09 financial crisis, government revenues returned to the early 2000s levels as the Russian economy struggled to haul itself back from recession.
Russia wasn’t an isolated incident as other East European countries have also struggled to reap the benefits of the flat tax regime. In most cases, inflows from tax revenues showed sluggish rather than spectacular increases.
Most of the former Soviet countries that have introduced a flat tax reform, accumulated severe budgetary shortfalls, in spite of sustaining a moderate level of economic growth over the years.
Although in most Eastern European countries fiscal deficits and the debt-to-GDP ratio have increased substantially since the introduction of the flat tax, a lean welfare system, which was achieved through the privatisation of the pension system, has unquestionably contributed in containing budgetary imbalances.
Slovakia highlights the irreconcilable differences between the euro a Flat Tax regime
One country that struggled to respond to the challenges posed by the flat tax is Slovakia. Slovakia is the only former Communist state to have introduced the flat tax and adopted the euro currency.
In 2004, the former Communist country introduced a flat tax rate of 19 percent on personal income, corporate profits and VAT. Prior to the introduction of the flat tax, the International Monetary Fund (IMF) representatives warned the Slovak government that marked reductions in personal income taxes were unaffordable and inadvisable. The IMF encouraged Slovakia to implement the new tax regime over three years rather than one year as the government preferred.
In 2013, four years after joining the euro and nine after introducing the flat tax rate, the newly re-elected left-wing government made a U-turn and opted to reintroduce a directly progressive income tax as part of an austerity package. The decision unquestionably helped the Slovak cabinet to increase the cash receipts as government revenues increased from 34 percent of GDP in 2012 to 40 percent in 2015, with all the main economic indicators also showing signs of recovery.
Slovakia’s U-turn highlights the challenges of implementing a flat tax regime within the Euro area.
One of the main issues would be the need to balance the books. The European Fiscal Compact requires governments to run balanced budgets and curb excessive use of public debt in the economy. With historic evidence suggesting that a flat tax regime widens budget deficits, at least in the short term, it is highly unlikely that the European Commission would take on the risk of destabilising the public finances of countries, like Italy, with high debt-to-GDP ratios.
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