Flat Tax Revolution Puts Europe on Edge

At the moment, the Euro Valley Industrial Park half an hour outside of Bratislava is not much more than a name.

Subcontractors to nearby Volkswagen Slovakia and other car companies inhabit some of the nondescript buildings, but much of the park is uninhabited or undeveloped. Euro Valley chairman Ivan Kocis, however, is not interested in the now, but in the future.

He is expecting all sorts of foreign investors, and his government’s decision last year to ratchet down tax rates to a uniform 19 percent is giving him reason for optimism.

“It is a very important factor,” said Kocis. “Compared to Austria, France and Germany, the companies pay almost half” of the taxes demanded by the government.

On Jan. 1 last year, Slovakia became the eighth eastern European country -- after Estonia, Russia, Hungary, Serbia, Ukraine, Lithuania and Latvia -- to introduce a flat-tax rate on income and corporate taxes. The model, adopted this year by Georgia and Romania, is considered by economists to be the best way to jump-start an economy, by luring foreign investors with low tax rates. But it is also leading to a clash between “old” and “new” Europe on the future of competition and tax reform in the European Union.

The money keeps rolling in

Slovakia’s trade and development agency, SARIO, is already reporting a jump in the number of foreign investment projects, from 22 to 47. The country, which has already attracted German giants like Volkswagen and Siemens, looks forward to posing more problems for western European governments looking to stop the flow of companies moving eastwards.

In addition to already cheaper labor, countries like Ukraine, Romania and Slovakia have offered up the flat tax as an additional incentive for foreign companies.

“It definitely puts pressure on western Europe,” said Kevin Waddell, an eastern Europe-based analyst with the Boston Consulting Group.

The giants respond

European economic giants France and Germany have already voiced their disapproval. Then French Finance Minister Nicolas Sarkozy (photo) said that if the new member states could “afford” a flat tax -- which traditionally leads to a decline in tax revenues -- they wouldn’t need financial help from the European Union. Chancellor Gerhard Schröder last year also criticized the new member states for taking aid from Brussels while stealing business from western Europe.

“It is certainly unreasonable that we finance an unbridled tax competition among each other via the budget of the European Union," Schröder said last May.

Germany, by comparison, has an average corporate tax of 38 percent, a rate that economists consider one of the big reasons foreign companies are bypassing the former European giant. But Schröder shows no sign of budging.

Resistance to change in Germany

When Germany’s council of economic advisors last summer recommended the government introduce a flat tax of 30 percent, their proposal was duly ignored.

“Most politicians don’t think they can convince the population of the need for a unified tax rate,” said Wolfgang Wiegard (photo), the head of the economic council. “The reason is the concern in Germany that the redistributive role of the tax system would be reduced.”

Like Sweden, Italy and France, Germany has a massive social net to support. A flat tax would mean taxing the rich at the same rate as the working class. More importantly, it would mean less tax revenues flowing into the government coffers and less money to pay for unemployment insurance, pensions, education and so on.

West should learn from east

Rather than adjust their tax rates too drastically, France and Germany are at the moment trying to push the EU into introducing a unified corporate tax rate. The strategy puzzles many in eastern Europe.

“Why should we be punished for the flat tax?” said Jozef Uhrlik, CEO of Volkswagen Slovakia, after a panel discussion in Bratislava last week. He then launched into a criticism of the union’s “irrational” labor policy, “unrealistic” environmental policy and massive agricultural budget.

“We have implemented something that is rational,” he added.

Drafted and passed by the Slovak parliament at an astonishing speed in 2003, the tax is being treated warily by some in Slovakia. As part of the reform, lower taxes on certain foodstuffs and products that had meant spending relief for the working class were eliminated. Opposition politicians are concerned about the long-term consequences for those who don’t earn much, as Slovakia angles for foreign companies.

“I’m not sure it’s fair to those people,” said Pavol Pesca, an opposition parliamentarian from the poor eastern city of Kosice. “Maybe it’s fair in a more developed country with a bigger middle class.”

But that’s exactly what Slovakia’s flat tax advocates argue will emerge in the central European country. The tax reform, they say, will reward the middle class for earning and producing more, provided the investment keeps flowing in.