Interview with Mart Laar on flat taxes

What especially commends flat rate taxes to transition and developing economies?

Flat taxes work so well because they are simple, fair and support the motivation of people to work more and to plan for their own future. The issue of motivation was particularly important after the collapse of Soviet Union nations in Central and Eastern Europe.

In December 1993, the ruling coalition in Estonia pushed through parliament a radical reform of personal income taxes, which became a flat 26 per cent level, against massive opposition from the ‘economic experts’. The effects were very positive. Budget revenues did not fall but instead increased significantly, personal income tax revenues doubled within two years. Black markets in Estonia disappeared and tax compliance improved. The introduction of the flat rate, proportional income tax helped to boost economic activity and create new jobs, helping Estonia to avoid massive unemployment.

The success of the Estonian tax reform encouraged Estonian neighbours to follow its example. In 1995, Latvia introduced a flat rate personal income tax and in 1996, Lithuania followed with a flat rate tax of 32 per cent. Comparing the unweighted GDP growth rates of economies in Central Eastern Europe with flat rate personal income taxation to growth rates of economies in the same region with progressive income taxation, we can see that countries with flat rates grew significantly faster.

The success of the Baltic tax reforms encouraged Russia, Slovakia and Romania to follow suit. The most radical tax reform was undertaken on 1 January 2004 in Slovakia where value added tax (VAT), the corporate income tax and the personal income tax were all fixed at a flat rate of 19 per cent.

So flat rate taxes have improved growth and created new jobs. This form of taxation has been very effective in fighting the black economy and increasing tax obedience. It is easy to pay but hard to avoid. Therefore, it is very good for the budget.

Do you consider flat rate tax systems to be the first-best fiscal institution at all stages of development or primarily for the catching-up process?

A flat tax system was first proposed by Milton Friedman and Alan Rabuschka for the ‘old’ capitalist countries to overhaul their traditional tax structures. They proposed it because it supports individual freedom, promotes economic activity, thus more jobs and growth. They also considered it to be fairer because flat rate taxes reduce bureaucracy and tax avoidance, although these latter aspects were not emphasized then. In the process of transition, these latter aspects of a flat rate tax system became much more important. Over time, the classic advantages of a flat tax become more important by fostering growth and activity.

So I think that the flat taxes will work well at all stages of development, because they are fairer and support economic activity.

Lump sum taxes (the same absolute amount instead of the same rate) would be economically more efficient —why not go for that?

Such taxes were often used in the ancient and medieval world and there are some scholars who are advocating them even today. In practice, such lump sum taxes have serious drawbacks. First of all, they tax poor people proportionally more. That is not a good way of collecting direct taxes from the poorest people: their tax share in revenue is small but the costs to collect them are high. This is the reason why in a flat rate tax system the poorer section of households is exempt from paying taxes, thanks to an income threshold that is too high for them.

Secondly, even in the most stable countries there is at least some inflation. Therefore, governments will have to change the lump sum quite often which is not practical. I think the flat rate tax is a better solution.

Progressive taxes are seen as being fairer to low income households —why should governments of transition and developing countries ignore that?

Progressive taxes ‘are seen’ as being fairer to low income households, but when you study what actually happens to these households under a progressive tax system, you find that it is not fairer. Flat rate tax systems have two rates – zero per cent for low income families and one fixed rate for all others – with exemptions primarily for the number of children. In reality, most exemptions in existing progressive systems are not so much helping low income families but middle income and high income families who actually do not need social support. Progressive systems make taxation so complicated that in many countries you need a specialist to fill in your tax declarations – it is quite clearly an economic burden. And at the same time it provides incentives for avoiding taxes.

Some argue that flat rate income taxes lead to more inequality of disposable income. The evidence from Central and Eastern Europe (CEE) proves the opposite: in the flat rate countries usually the inequality as measured by the GINI coefficient is not increasing but decreasing.

Low proportional tax rates weaken the automatic stabilizers (revenues varying in line with the business cycle, reducing disposable income in a boom and increasing it in a recession) of the government budget – can transition and developing countries afford that?

I don’t think so. First of all it is clearly seen that transition and developing countries can afford low proportional taxes – their revenues will be higher and finances healthier thanks to this tax structure.

As I said before, if we compare budgets of the flat rate countries with the budgets of non-flat rate countries in the same region, we find that the former are financially healthier. Of course, this is not due only to the flat rate system, but flat rates help. In theory, the picture may be different for so-called developed societies, where the automatic stabilizers can play a more important role. But even then I do not think that one should solve other economic problems such as stability with different taxes. Governments should only care about keeping the budget balanced. When they fail in this regard, automatic stabilizers will not help.

How do you respond to allegations that flat rate tax reforms introduce a form of tax competition that is not compatible with the solidarity principle of the European Union?
I do not think that the solidarity principle has anything to do with tax competition. This would only be the case if countries lowered taxes to a level that would jeopardize their financial stability. But CEE countries with low flat rate taxes have in fact collected more revenue. They are developing faster and are thus moving to a level where they will become net payers to the EU budget.

In this context, the example of Ireland is telling: by using lower taxes, one of the poorest countries in Europe became one of the richest. Solidarity in Europe means to move new member states as quickly as possible to the same level of development as ‘old Europe’.

So, on the contrary, I am convinced that tax competition – which will push down taxes everywhere in Europe – will make Europe more competitive. For the new member states it is not only important to rejuvenate their countries, we want to rejuvenate entire Europe.