Thursday, October 12, 2006

Flat tax - an idea whose time has gone

The final sentence of the International Monetary Fund's new working paper on flat taxes should dampen the enthusiasm of anyone who sees flat taxes as the answer to life, the universe and everything: "While there will no doubt be new members of the flat tax community, in some respects the more interesting question is whether there will be any defections."

Yes indeed. Because the empirical evidence to support the wilder assertions about the flat tax idea just ain't there, as the working paper's conclusions spell out in stark terms.

Drawing on the experiences of a wide variety of Eastern European countries, the authors conclude:

* " . . in no case does there appear to have been a Laffer effect . . And in Russia there is little evidence that the strong revenue performance after the reform was due to the flat tax itself: rather it appears to have reflected wider macroeconomic recovery."

* whilst there is evidence that compliance has improved in Russia "there is no firm evidence that it was due to parametric tax reform rather than to changes in enforcement occuring around the same time."

* There is no evidence that the impact of the flat tax on work incentives has been strong in practice. The only study to date of actual household responses to the introduction of a flat tax - for Russia - "does not detect any significant impact on work effort".

* The introduction of a flat tax system does not significantly reduce the complexities of a tax system. The principal sources of complexity arise from exemptions and special treatments, not from the tax rates per se.

* Rate cutting in some countries has "enabled significant broadening of the tax base through elimination of exemptions and preferential treatments". This has contributed to improved horizontal equity, some efficiency gains and greater simplicity.

* In almost all cases the flat tax was adopted by new governments "anxious to signal a fundamental regime shift towards more market-oriented policies. Where no such reputation needs to be acquired, the appeal of a flat tax is consequently less."

The authors also note that "the flat taxes that have been adopted do not provide a coherent framework for dealing with the difficulties that almost all countries now perceive in taxing internationally mobile capital income."

All in all, the available evidence suggests that flat taxes fail to achieve what it says on the can. Time to switch attention back to how to strengthen progressive tax regimes to protect them against predatory and harmful practices.

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