Flat Tax Gains Ground
August 21, 2007
When Bulgaria's Institute for Market Economics (IME) began touting a flat tax system for the country in the 1990s, it was seen as a crazy free market idea that would never become reality. But a lot has changed in the past decade. Bulgaria's neighbors have launched a tax revolution, with a total of nine Eastern European and former communist countries shunning progressive tax systems in favor of a simple, one-rate-fits-all model of taxation.
In Bulgaria, flat taxes are no longer the exclusive domain of free market dreamers. Fresh from introducing a flat 10 percent tax on corporate profits, Bulgaria's socialist-led coalition government now wants to do the same for personal income.
Besides switching to a flat tax, the Bulgarian government also wants to cut social insurance contributions by 3 percent and increase pensions by 10 percent. Details of the tax proposal are being debated within the governing coalition.
Fuel for economic transition
Svetla Kostadinova, who heads the IME, a free market think tank based in Sofia, said she's confident that starting in 2008 Bulgaria will have a flat tax in some form. Kostadinova said she thinks the flat tax will further fuel Bulgaria's economy and cut down on the informal economy, which is often used to avoid taxes.
"We think that the flat tax idea is a good approach for small transitional economies that want to reach European levels of income faster than the usual way," Kostadinova said. "Small countries more easily take such decisions."
With its 10 percent rate, Bulgaria sits at the low end of the flat tax spectrum while Lithuania's 33 percent is at the top end. Estonia, Latvia, Russia, Ukraine, Slovakia, Georgia and Romania have also switched to flat tax systems in recent years.
It's too soon to say how much of an economic boost Eastern Europe has gotten by switching to a flat tax, said Dutch economist Wouter den Haan. Furthermore, flat tax schemes are only one part of the economic growth of Eastern Europe. Many have joined the European Union and are realigning their economic policies to switch over to the euro.
Czech government looks to shrink deficit
The Czech Republic is launching major economic reforms to try and get its deficit under control. Part of its reform package includes a flat tax. The ruling center-right coalition said if its tax reform package falls apart, it will seek an early election.
Coalition leaders agreed to adopt a 15 percent personal income tax last week. The rate would drop further to 12.5 percent in 2009. The income tax currently maxes out at 32 percent. The government also wants to decrease the corporate tax rate to 21 percent in 2008 and down to 19 percent by 2010. A vote on the reform package is expected in the next week.
Tax break or tax increase?
But Eastern Europe isn't an economic miracle. Many countries face hefty current-account deficits and high inflation rates. In Bulgaria, there's also been widespread concern in recent weeks that the flat taxes will hurt poor people and families.
The average wage in Bulgaria is 350 leva a month (179 euros, $241). People who make less than this amount, as well as freelancers, will pay more under the new tax system, the Bulgarian media has reported.
There's a common misconception that all forms of flat tax place undue burdens on the poor, said den Haan, a professor at the University of Amsterdam. In many cases, only incomes above a certain threshold are taxed, which can make the system quite progressive, he added.
While progressive income tax systems in Western Europe are aimed at taxing the wealthy at higher rates than the poor, it often doesn't work out that way.
"Our current tax system isn't as progressive as people think," den Haan said. "That's because of all the tax deductions."
Western Europe remains skeptical
Western Europeans looking to get rid of a complicated system of tax deductions and exclusions, however, are unlikely to see a flat tax any time soon, economists said.
Friedrich Merz, a German financial expert with the center-right Christian Democratic Union (CDU), declared a few years back that taxes should be simple enough to fit on back side of a beer coaster. Even so, it remains likely that Europe's pension systems will keeps its largest economies form adopting a flat tax.
Most countries in Western Europe have long-standing social security systems which are funded by the redistribution that comes from progressive tax systems that get higher revenues from the rich, said Linda Yueh, a visiting professor at the London Business School.
"To some people, including some views from Western Europe, a flat tax is a free market mechanism because there's no redistributive aim," Yueh said.
Taxpayers also like the idea of exemptions and the feeling of getting money back from the government, den Haan said, adding that people can see how specific exemptions benefit them and don't want to lose those benefits.