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Get Ready for the Flat Tax Debate

By Joff Lelliott - posted Monday, 19 September 2005


Recent debate on tax reform in Australia contains a surprising feature - unlike debate on tax reform in other developed nations, a flat tax is not even on the radar. However, passing references in the media suggest the debate is not far away and if it does not surface in this round of debate it almost certainly will in the next.

Various models of flat tax are promoted, but the essential components are, first, that all income tax payers pay the same rate. Second, this single income tax rate is aligned with the corporate tax rate, with some arguing that GST / VAT and other taxes should also be brought in to line. Last, supporters argue that it removes exemptions and loop-holes and thus makes the system simpler and fairer.

Critics argue that flat taxes penalise the poor, reduce tax receipts, lessen government services and are designed to make the rich richer. They also point out that supporters of flat taxes are the same people who have long pushed for tax cuts for the rich and cuts in public services and welfare. Supporters counter that the single tax rate assists the poor, along with everyone else, because it encourages hard work and entrepreneurialism, leads to higher tax receipts through economic growth, discourages tax evasion and makes the system simpler by doing away with arcane rules.

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So whilst in Australia various experts, media pundits and politicians argue about whether there should be three, four or five income tax bands and whether the top rate should be 35%, 40% or 45%, the argument in other countries is more polarised, with those who support a progressive tax regime pitted against those who support a regressive flat tax.

Flat taxes were first mooted as far back as the early 1980s by Robert Hall and Alvin Rabushka. When American businessman Steve Forbes was seeking a Presidential nomination a decade later, it was one of his key - but apparently eccentric - policies.

But the debate is not purely academic. In 1994 Estonia introduced a flat tax and set off a domino effect through out Eastern Europe. Before long the other Baltic states, Romania, Slovakia and Russia, had introduced flat taxes. Sometimes the rate was in the 20%-30% range, but more often it was in the teens.

Eleven countries now have flat taxes - ten in Eastern Europe, plus Hong Kong. There is an orthodoxy amongst many - including opponents - that flat taxes have had a beneficial role in Eastern Europe by reducing tax evasion and stimulating growth. But in Russia, for example, David Walker in The Guardian states bluntly that “men in balaclavas with automatic weapons seem to have been more effective in boosting compliance”. Writing in the Financial Times, Charles Robertson, who is Chief Economist for Emerging Europe, Middle East and Africa at ING, argues that high economic growth in Russia was due primarily to high oil prices rather than flat tax.

Proximity to Western Europe and the accession of much of the former Eastern Bloc to the European Union last year ensured that the debate has been successfully exported westwards. Many West European countries are now examining flat taxes as a way of staving off competition from the new Eastern members and reviving long-stagnant economies. Denmark, Greece, Italy, the Netherlands and Spain are considering flat taxes, and the debate has now reached the mainstream in Britain and Germany. During last week’s television debate in the lead up to the German election, Angela Merkel of the right-leaning CDU-CSU argued a flat tax might be needed as part of an overhaul of the German economy.

In Britain, Shadow Chancellor of the Exchequer George Osborne last week launched an enquiry into the feasibility of a flat tax for Britain. The model being investigated comes from the neo-liberal Adam Smith Institute. It also reveals the central problems with flat taxes. The model suggests a £12,000 (AU$30,000) threshold and a flat 22% rate from then on. No one pays more tax in this model and there are many winners. But the net result is obvious - tax receipts would fall. Actually, they would not so much fall as plummet - by £50 billion (AU$125 billion) or 10% of total tax receipts. Savage cuts to public services would be needed to balance the books. The Economist asked PriceWaterhouseCoopers to provide a model that would leave total tax receipts intact. This model has a £10,000 (AU$25,000) threshold and a 30% rate. It still helps the poor and happily for the rich they are massively better off too. Unfortunately the cost is borne by the middle third of taxpayers, some of whom would be £1,400 (AU$3,500) a year worse off.

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The Conservative model only includes the revenue lost from income tax. When Slovakia introduced its flat tax, corporate tax receipts fell by 20% from aligning it with the single income tax rate.

The Blair government strongly opposes a flat tax, arguing that it would necessarily lead to a reduction in public services. It seems Labour has won the debate in Britain before it starts. For all the other complaints about Tony Blair’s government, two things are indisputable. First, people now largely trust Labour more than the Conservatives on the economy. Second, Blair has successfully convinced most people there is a clear link between the amount of tax paid and the level of public services provided.

Clearly then, a flat tax is problematic for a modern economy wanting to maintain good public services.

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About the Author

Dr Joff Lelliott is a part-time writer with a Masters degree in sociology. He is a long-time football fan.

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