Flat Tax Revolution in Central Europe

Flat Tax Revolution in Central Europe

Backgrounder:

Flat Tax is type of taxation structure where everybody is taxed uniformly at a single rate. Under such a system, in place of a multiple and intricate income tax slabs, the state stipulates a ceiling, exceeding which everyone pays a fixed rate on all their income. With a view to encourage tax payment instead of tax evasion, the ceiling limit is fixed low enough which provides an incentive for the citizens to pay tax. Under the Flat Tax system, there is a single taxation on its inception. In respect of corporate tax, the concept is also similar where there is a similar structure for everybody. Several countries have adopted Flat Tax is a phased manner starting with Estonia in 1991, Latvia in 1994, Lithuania in 1994, Russia in 2001, Serbia in 2003, Ukraine in 2003, Slovakia in 2003, Georgia in 2004 and very recently Romania in 2005. Even though Flat Tax is not hyped as the cure-all for every economic problem, more and more European nation and out of them a few nations who have recently joined the EU fold have introduced or are preparing for a single tax structure. (Flat tax: www.euractiv.com)

The problem for most of these countries is that there is a high level of budget deficit and many countries are confronted with the necessity to align their economic position with the Eurozone's needs. The merits of Flat Tax are to (i) help in the reduction of bureaucratic tardiness and its connected problems and uncertainty. (ii) Lower the problem of inequity by fixation of an identical rate for everybody (iii) offset tax evasion and corruption. (iv) Provide drive to work, save & invest (v) yield increased revenue by way of taxes and therefore (v) kick-start an economic boom in a small scale. On the other hand, criticism leveled against Flat Tax are that it (i) eliminates almost every types of tax exemption and allowances (ii) unprogressive so far as the 'marginal rates' (iii) skewed in favor of the rich at the cost of the poor (iv) supportive of the people who receives dividend as profits are taxed at source only indicating that Flat Tax is a consumption-based tax. (Flat tax: www.euractiv.com)

Burning Issues:

It is debatable if the apparently popular changeover to a Flat Tax system is propelled by a sound fiscal policy or it is one more ploy by the state authorities to make the taxpayers dish out more to fill the Government's treasury. One important decision by several research professionals is that the competence and success of a Flat Tax system is intrinsically dependent on the real rate of the tax rate which means the lower the tax; the more efficient it tends to be. Specialists' even point out to the fact that a nation's level of competitiveness is determined by several other factors apart from the tax system or the nature of support the nation renders to fresh investments. Whereas it is a fact that a lower tax rate system leave more money for circulation and therefore to be invested in an economy, and flat tax rates normally increase the eagerness of the citizens to deposit their taxes, lower rates of taxes also implies lower tax revenues, which in turn may be unfavorable for the particular state's budgetary position. (Flat tax: www.euractiv.com)

Moreover, many leaders of the Europe's well performing economies like German Chancellor Gerhard Schroder and Prime Minister of Sweden Goran Persson have stated that transition economies of Eastern Europe can manage to lower taxes not least since any revenue loss is more than offset by heavy subsidies from the EU. This disagreement has continually been countered by those 'transition' states that are affected. In the meantime, Germany, as also Italy, Austria, Finland, Denmark & Greece have too decided to effect tax cuts in various categories so as to improve investment and spending and encourage growth. According to Wolfgang Wiegard, adviser to the German government, suggestion for a flat rate of income as well as corporate tax would increase investment in Europe's biggest economy. In keeping with the proposal, Germany must administer a flat tax rate of 30% on all personal and corporate income. Wiegard had observed that majority of the older members of the panel support the flat tax, as against the younger economists who are in favor of the dual income tax.

Prime Minister of the Czech Republic, Stanislav Gross agrees to a simplified tax system. But at the same time while declaring that the growth rate of his country is double compared to the average of the eurozone, he also announced that his administration will not launch a flat tax regime. There can be no end to the debate. Everybody has their figures ready depicting that government revenue rising with the fall in taxes. Nevertheless, this debate need not have to be shown in charts or tested exclusively in lecture halls, stated by Bloomberg columnist Matthew Lynn. Flat Tax has been introduced in many erstwhile communist countries for the last few years and until now, the proof shows they are delivering. (Flat tax: www.euractiv.com)

Flat Tax in Czech Republic:-

Currently the rates of corporate tax in the Czech Republic are 26% which puts a lot of pressure. Hence, it is crucial that the Czech Republic needs tax reform or Slovakia will race ahead of Czech Republic for procurement of business investment. This particular intra-regional tax war shows the competition to investment is ahead of South-East Europe, but the economy of Czech is much at a matured level compared to Bulgaria and Romania which are at the learning stage. The Czech Republic is capable of drawing a considerable amount of investment in the absence of drastic economic or legal reforms. There are reasons behind the nation having a more matured market compared to those in the southern Europe. Even though tax is one of the factor in drawing business, matters like geographic location, quality of life and laws relating to employment also impact where a company establishes a regional headquarters. The progress of the Central and Eastern Europe -- CEE accession states into mature markets implies that they can deal with intricate transactions and complicated legal structure, discarding the fallacy that the nations are in the initial phases of legal development akin to those in southeast Europe. (Slash and Earn)

On the other hand, Estonia began with the Flat Tax system in 2004 with an initial rate of 24%. However the achievement has been good. The efficiency of the companies is rising, the performance of the economy rises at a quicker speed compared to the Czech Republic and the administrative load that comes with filing the tax returns has been lowered and the discipline regarding payment of taxes has bettered. It is important to note that Slovakia exceeds the Czech Republic and imposes a 19% Flat Tax rate. According to Slovak Finance Minister who described the public finance system, taking into account the helpful aspects and benefits for Slovakia launched by the widespread reforms. Currently, the tax liability in Slovakia is the third lowest within the EU member nations; the decrease of this tax load has been the greatest among all the EU nations during the last eight years. Latvia who has introduced the Flat Tax regime is a nation that boasts of one of the lowest tax burdens within the EU. Moreover, it has also established the practicality that launching of the Flat Tax does not always indicate a collapse of the budgetary income of the state. (Mirek Topolanek joined by ODS foreign partners supporting the introduction of a flat tax in the Czech Republic)

The Present Tax regime in Czech republic:

Income Tax rates in the Czech Republic are nearly average for the EU. The rate of Corporate Tax is presently 28% which is going to be reduced to 24% by the year 2006, whereas personal income tax ranges within 15 & 32%. Till recently, the Czech Govt. headed by left of centre Social Democrats appeared quite content with the situation, however presently, with the possibility if the Czech Republic approving the Euro in nearly five years time, the government is starting to implement more and more radical reforms. The Opposition Civic Democrats have been charging the Govt for extremely high rate of taxation since a long phase. At one point of time their MPs Vlastimil Tlusty referred that, they have been advocating a "flat tax" rate of 15% which would be imposed not considering income, and a flat Value Added Tax would also be present. However, flat tax is rational, and because of deductions, it will be easier in case of individuals with lower incomes. Currently, the Czech Republic various rates of income tax rates are present starting with 15% which is the lowest one. In case the lower tax rate is implemented, it would imply that it will be implemented in the lowest level. Any nature of tax cuts is widely greeted by the experts of the economy. Considering both the beneficial aspects as well as the downside, the general pattern which will emerge will definitely be advantageous for the Czech economy. (Can the Czech Republic expect sweeping tax cuts)

The vital characteristic of tax competition is the strength of percept. Moreover the flat tax lends a good illustration. More than half of the nations belonging to the Central and Eastern Europe have initiated the flat tax regime. It has been observed that their growth rate is double as compared to the rest of the half of those who are continuing with the intricate system of progressive taxation. Considering the scenario, it is considered that economy of Czech Republic will grow doubly fast when it has a flat tax system. The four basic benefits of a Flat Tax are (i) fosters faster economic growth (ii) lower tax evasion (iii) lower Governmental and administrative expenses, for the Government as well as the taxpayer. (iv) Lower need for social benefits in case of families having low income since this makes a leeway for a greater personal allowance. (Flat Tax and Tax Competition)

The Flat Tax proposal of ODS:

The basic idea behind introduction of the Flat Tax proposal is to render the tax system more transparent and equitable. The present system has four tax slabs is seen as considerably progressive that might wane work incentives. The implementation of the Flat Tax must be done in several steps. The most vital is the introduction of a single 15% tax rate, chargeable on income of both physical and legal individuals. The lowering of the tax rates must be compensated by abolition if tax deductions, exemptions and exclusions. Under the present condition, 11 types of personal incomes are in existence which are not taxed, 26 items which can be eliminated from the tax base, 57 items which enjoy exemption from payment of taxes and 34 items which attract a special lower rate. ODS makes a case that removal of these special cases would amply widen the tax base and therefore the reform would not raise the budget deficit. The impact of the Flat Tax are extremely susceptible to the stricture of the reform i.e. tax rate and the amount and provision of deductions. (Redistribution of Income Through Taxes and Benefits in the Czech Republic Between 1989 and 2000 and Beyond: Observation and Simulation)

Two measures are being used to show an example of the effect of the reform. The 1st one relates to the share of the household that is exempt from payment of any tax, in accordance of the employment position of the head of the family. The 2nd one indicates the fiscal ramifications of each of the proposal, the change of the net tax revenue comparatively to the present state. It has been proposed by the ODS to impose a 15% tax which is presently the least tax bracket in which includes the majority of the voters and it appears that this is the maximum rate the voters will be prepared to accept. Comparing the various Flat Tax situations, taking the default proposal that each monetarily viable taxpayer gets a basic deduction of 6,000 CZK on a monthly basis, it is observed that the sections of households who would come outside the purview of the tax would rise considerably. Whereas under the current system a mere 1.7% of the households having a job do not pay any income tax, with the 6,000 CZK deduction, this figure will be 4.3% in case of household whose head of the family is employed and even 19.7% in case the additional deduction of 6,000 CZK is permitted for every dependant child. (Redistribution of Income Through Taxes and Benefits in the Czech Republic Between 1989 and 2000 and Beyond: Observation and Simulation)

However, in case the calculation reveals that in case the deduction is allowed just for the economically viable members and not for other persons -- for instance in case of the spouse with low earnings as under the present system, some of the household's financial condition will deteriorate. The difference between deductions for every economically viable and for every adult in the household is equal to the distinction between the two separate tax units: in cases when every individual is taxed and in cases when households are taxed. The fiscal costs of the reform measure would be, with deduction of 6,000 CZK monthly, nearly 30% of the current revenue. Therefore, if the estimated revenue for 2002 is 110 billion CZK, the anticipated costs of the Flat Tax reform would be to the tune of 33 billions i.e. 1.7% of the GDP. In order to make the reform fiscally neutral, the rate of the Flat Tax must be 22% in place of 15%.

But, at the moment, presently 77.8% of the households have the tax base so low that they are taxed by the15 to 20% rate. Besides, as the unit of taxation is an individual, and not a household, 22% rate would deteriorate the financial condition of more than 80% households. Nevertheless we have to assume that such type of calculation is only static. It is expected according to the plan, Flat Tax could enhance collection of taxes and augment the labor income of the family and therefore lower the expenditures for certain social benefits. Especially, it could reduce the expenditure for the next year on means-tested social gains whose level is determined by the average monthly income in the previous calendar year. (Redistribution of Income Through Taxes and Benefits in the Czech Republic Between 1989 and 2000 and Beyond: Observation and Simulation)

Position of adoption of Flat Tax by the Other Eastern & Central European nations:

Estonia set the ball rolling by adopting the Flat Tax at the rate of 26% after a few years of the dismantling of the Soviet Union. Latvia chose to implement a 25% rate and Lithuania following suit with a rate of 33%. In concert with the other free market reform movements, the Flat Tax considerably improved economic growth. Adoption of the Flat tax fashion quickly spread with Slovakia adopting it in 2003 with a 19% rate. The success of the Flat Tax revolution has been such that Estonia is reducing its rate to be abreast with other countries. Estonia has dropped its Flat Tax to 24% and it is proposed to go down to 20% by the year 2007. But this is just the starting. (Viewpoints: Eastern Europe's Flat Tax Revolution)

Law making resource persons in other nations like Croatia, Bulgaria, and Hungary are examining the modalities of the Flat Tax, and the opposition parties in Poland and also the Czech Republic assuring to implement 15% Flat Tax rate system in case they emerge victorious during the next elections. By every yardstick, the system of Flat Tax in Central and Eastern Europe has been beneficial for Govt. As well as the private sector. Since the introduction of the Flat Tax in other nations has been in the nascent stage, hence it is difficult to come to any inference. But, it is worthwhile to note that the response was so remarkable both economic growth and tax collections surpassed the anticipated collections in the inaugural year of introduction of Flat Tax in Slovakia. (Viewpoints: Eastern Europe's Flat Tax Revolution)

Possible Benefits of Flat Tax:

The system of Flat Tax contains all the principles of a good tax policy and some of these are as follows: (i) Under the Flat Tax regime, income is taxed at the lowest practicable rate to promote a pro-growth behavior. The marginal rate of tax constitutes a price which the Govt. enforces on efficient economic behavior. Flat Tax systems are devised to have a low rate, implying that people are not taxed for work, taking business risks and entrepreneurship. (ii) Flat Tax is imposed only once such that there is no favoritism against savings and investment. A crucial element of a pure Flat Tax is the removal of the tax bias against income which is saved and is put into investment. This ensures that there is absolutely no other tax like Capital Gains Tax and taxes on dividend are free and no IRA treatment for all savings. All the Central and East European nations' flat taxes have satisfied each of the above criteria; however double-taxation of capital has been considerably lowered. (iii) Social Engineering is eliminated as also industrial policy through the removal of special interest flaws. Special tax breaks have a tendency to alter the allocation of resources and thus weaken economic growth. (Viewpoints: Eastern Europe's Flat Tax Revolution)

The Flat Tax attempts to remove or minimize the effect of the tax code on decision-making through treatment of every income at par, irrespective of the manner of its earning and its avenue of spending. Eastern European nations particularly Slovakia and Estonia remarkably have lowered benefits in the tax code. Besides, the above principal benefits, other important principles of a good tax policy are fulfilled by the Flat Tax, including that it is simple to calculate and comprehend and its territorial applicability. Due to all these causes, introduction of Flat Tax in the Eastern Europe has been a tremendous success and the coming years will reveal their real success.

Due to this, some detractors of tax reforms are attempting to belittle the spectacular developments in Eastern Europe. They have a genuine fear that these nations are instances for America and other Western countries. Tax reforms in the Eastern Europe have been a tremendous success, and it can serve as a good guidance for the United States basing on what has been done in other countries. The most important lesson learnt from the experiment of Flat Tax is that a nation can liberate itself from the evil impact of the class war. After having taken a leaf from the dreadful outcome of an economic system based on "ability to pay," the Central and Eastern Europeans have in its place preferred a tax system based on the ideology that every citizen must have an equal treatment. (Viewpoints: Eastern Europe's Flat Tax Revolution)

The pros and cons:

A progressive tax system when replaced by a Flat Tax system lowers the taxes for the richest people inside the society. This is definitely a strong case in support, in case one represents among the richest people inside the society. As these people influence opinion forming organizations, inclusive of newspaper, electronic media, and political parties, a lot of such organizations support a system of Flat Tax. Several of the supporters of the Flat Tax system put forth that this system might questionably possess majority of the benefits of a progressive tax system, depending on if the flat rate is mixed with the considerable limit. Generally, the Flat Tax is planned to be placed at a certain income level, or to waive the income below that level, such that the members who are in the lowest strata of the society is not liable to pay any income tax. There are some who debate that this is technically a two-bracket progressive tax instead of a Flat Tax, but on the other hand others hold that the lowest tax bracket constitutes a zero tax rate, thus making it an exemption rather than a tax bracket. (Flat Tax: www.absoluteastronomy.com)

However, both the sides consent that theoretically, in case the income of the poor is exempt from taxes, although those who are against, indicate that this is difficult to implement when the affluent are required to pay less. Supporters of a Flat Tax sometime propose to raise the "zero tax" level so as to include working class citizens, as an avenue to avoid raising their taxes at the time when the Flat Tax is launched as the majority of the working class citizens at the moment pay less taxes compared to what they would under a Flat Tax regime. On this point also the detractors indicate that this is difficult to attain when the affluent are required to pay less. Those who oppose, refer that the present tax code could be simplified, and the shortcomings i.e. various exemptions and deductions can be eliminated without increasing the tax brackets. The amount of income which the Government collects from the proceeds of the Flat Tax depends completely on the level of tax. Normally, Flat Tax is proposed by the parties whoa also believe in tax reducing program, however a Flat Tax could be used to augment government revenue by just raising the rate of tax. (Flat Tax: www.absoluteastronomy.com)