Friday, March 03, 2006

Eastern Europe: riding the flat tax bandwagon?

Does progressive taxation have a future or is it caught in terminal decline? I have written about this topic a couple of times, most recently emphasizing the "I" countries (Italy, Israel, India) (the title of this blog is derived indirectly from that article). But events have a way of overtaking academics, and right now the biggest assault on progressivity is taking place not in Milan or Mumbai but somewhere between Munich and Moscow, in the swath of land we used to call satellite countries and Donald Rumsfeld referred to famously as "the new Europe."

In the last few years one Eastern European country after another has adopted some form or other of the flat tax, often with much political fanfare. According to the Christian Science Monitor, as of last year no fewer than nine countries in the region had adopted a flat tax (Georgia, Estonia, Latvia, Lithuania, Russia, Romania, Serbia, Slovakia, and Ukraine), six of them at rates lower than 20 percent and only one (Lithuania) at 30 percent or higher. Nor have the potential implications of these adoptions been lost on flat tax supporters or opponents: the CSM article contrasted the excitement of the young technocrats, many American-trained, who had helped enact the new flat taxes with the frustration of West European bureaucrats who saw them stealing jobs and undermining efforts at European tax harmonization.

The spread of the flat tax in Eastern Europe is especially interesting given what might be called the flattening out of tax rate schedules, still nominally progressive, in other European and non-European countries. For example, the Italian income tax now has only three rates (23, 33, and 39 percent) and the German two (15 and 42 percent) although there is an additional "temporary" contribution that forces the maximum Italian rate up to 43 percent. A similar process of flattening out may be observed in the United States since the 1986 Tax Reform Act, although that act also reduced a number of popular tax breaks and was thus at least theoretically neutral between income classes, as were several foreign tax reform processes. (Progressivity is always a combination of tax rates and tax base, although without some measure of progressivity in the tax rates it is obviously more difficult to achieve an overall redistributive result.)

Does the East European phenomenon portend a worldwide momentum toward a flat tax? I am skeptical on this point, for a couple of different reasons. First, I am always dubious about "global" movements that are concentrated in one geographic region. There is always the possibility or indeed likelihood that the nations in the area are influenced by each other, rather than following a larger ideological trend.

Second, the Eastern European countries have characteristics that are not shared by most industrialized nations. The communist heritage has made them uniquely suspicious of redistributive measures, and--lacking a tradition of private trust or voluntary cooperation with the central government--they may be happy to receive such tax revenues as they can, especially from newly developed economic sectors. As the CSM article noted, every flat tax country except Hong Kong is a former Communist nation, and that only a partial exception.

Third, as noted above, the "flat" tax systems tend to have substantial zero bracket amounts which render them at least partially progressive, and have often been accompanied by efforts to widen the tax base which (depending upon enforcement mechanisms) may actually result in an improved level of real tax fairness.

All of that said, political trends tend to take on a momentum of their own, and whether something ought to happen is often a different question from whether it does. In this respect it will be interesting to watch events unfold in the next few months. Greece, which is georgraphically in Eastern Europe but economically and culturally tied closely to the West, is a particularly interesting case to follow. If it were to adopt a flat tax, as has often been discussed, it might lead to greater political momentum in the larger European countries. Angela Merkel, the new and increasingly assertive German leader, has also toyed with a flat tax although Germany's budget problems complicate matters considerably. We will know that the flat tax has made it when it reaches (say) Denmark, where marginal rates remain around 60 percent: but that is a story for another column.


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