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Flat tax reforms in Estonia and Slovakia
Flat tax reforms in Estonia and Slovakia can be the models for Croatian tax reform. The political will is neccessary in order to stimulate growth.
The article examines main features of the flat tax policy and brings a research overview of flat tax reforms in Estonia and Slovakia. It can be emphasized the flat tax reforms in Estonia and Slovakia had positive effects on tax revenues and GDP growth. However, rapid economic growth rate in these two countries needs to be seen from much broader perspective, as consequences of various structural liberalisation reforms, including the flat tax reform.
Flat tax policies have already been implemented in the vast majority of Eastern European countries, with the aim of more simplicity, fairness and neutrality in the tax system, with savings and investment incentives. The flat tax means a single tax rate on personal and/or corporate income and/or VAT, without any exemption or deduction, except personal allowance.
FLAT TAX – MAIN FEATURES
The flat tax has also been called „proportional tax“. It means a constant marginal tax rate for all personal and/or corporate incomes, and/or VAT (Kesner-Škreb, 2005). Therefore, a proper term would rather be “flat taxes”. The flat has mostly been related to personal income taxation, which replaces progressive marginal tax rates with the proportional, equally treating all incomes through the single rate. In fact, the single rate system is not necessarily the flat tax in its pure form. Emes and Clemens (2001) argue that flat tax means the single rate, including personal allowance, and excludes any tax deductions and exemptions.
In the 19th century most countries had the flat tax, while in the 20th century many countries converged towards progressive taxation (Baturo and Gray, 2007). Therefore, the flat tax has not been a new fiscal policy instrument, while progressive personal income taxation was proposed by Karl Marx (Basham and Mitchell, 2008), as one of socialist policy proposals for the income redistribution, in order to achieve “social justice”. In fact, as this term cannot have a precise meaning, social justice could also be defined in other ways. Therefore, the flat tax idea has been based upon the principle that the tax system needs to be just, which could be achieved only if all personal income shall be treated with equal marginal tax rate and without exceptions. This brings a new perspective on the idea of social justice and equality.
The flat-tax idea was put on the policy agenda after the World War II, with prominent thinkers of liberalism such as August von Hayek and Milton Friedman. In 1962 Friedman proposed a 23.5% federal income tax for USA and maximum 20% in 1980 (Socol and Marius, 2009). The flat tax idea has been one of main features of liberalism, as a part of comprehensive tax reform model which would create open investment environment for economic growth. Although the flat tax proposals originally come from the United States, countries that have enacted this model are mainly Eastern European transition countries, as well as other non-European countries, such as Hong Kong. In Western Europe, only Iceland has the flat tax, while there are discussions related to that topic in many other countries.
Hall-Rabushka flat tax proposal holds its progressivity through the amount of basic personal allowance and low marginal income tax rate. Deductions and exemptions are not allowed, which means that it is applicable to a broad tax base. The flat tax decreases the tax burden and the possibility of tax evasion. Its simplicity reduces administrative costs of taxation (Kesner-Škreb, 2005). In 1983 Hall and Rabushka proposed 19% flat income tax for companies and individuals in the United States, including personal allowance, while other income exemptions were not allowed (Rosen, 1999). The flat tax is based on a consumption tax principle. Therefore, people are taxed on what they take out of the economy, not on what they put into it. The flat tax gives work incentives, increases take-home wages and stimulates capital formation (Hall and Rabushka, 1995), switching the tax burden from income towards consumption. Hall and Rabushka (1996) argue that income tax with an exemption for saving is a consumption tax, as a difference between income and saving. Expensing investments eliminate double taxation of saving. Efremidze (2007) adds that consumption taxation discourages consumption and stimulates saving.
The aim of the flat tax is to stimulate income savings and capital accumulation in order to increase private investment opportunities. Therefore, uniform top marginal income rate results in more disposable income. Those personal incomes could then be saved for investments or consumption as well. Furthermore, tax administration can get even more revenues. The tax base becomes broader with more economic activities, through higher investments and employment, and new taxpayers, who were exempted from the tax duty or foreign investors. Also, reduced tax rates can stimulate economic activities by shifting them from informal into formal economy, which bring even more tax revenues.
The flat tax produces a comprehensive tax base which results in fairer distribution of tax liabilities among those with equal incomes. Therefore, taxpayers could not be able to shift a proportion of their incomes into untaxed forms. Moreover, the flat tax system includes personal allowance which means that the amount of non-taxable income can even be increased, so lower incomes could benefit (Browning, 1985).
The majority of progressivity can be achieved through personal allowances and very little by progressive tax rates. Therefore, flat tax rate for individual incomes, including personal allowance and abolishment of all tax reliefs should be proposed. Tax revenues would be the same, with around 90% of progressivity as in the current progressive system. The goal of the tax policy is to collect sufficient tax revenues, with larger simplicity and transparency, less costs and less harmful effects on efficiency (Urban, 2006).
The flat tax can include (horizontal) progressivity with higher personal allowance, instead of vertical progressivity through higher marginal tax rates on individual income (Emes and Clemens, 2001). Therefore, the flat tax is progressive, because the poor would pay no tax (Hall and Rabushka, 1995), different from regressive character of VAT (Hall and Rabushka, 1985). Moreover, the central principle of the tax reform is limiting the tax burden on the poor, which does not require graduated tax rates (Hall and Rabushka, 1996). The flat tax indirectly keeps progressivity. While the marginal tax rates remains constant, average personal income tax rate keeps its progressivity (Blažić, 2006).
Therefore, two concepts of taxation progressivity can be distinguished. Traditional (direct) concept understands taxation progressivity as the amount of personal income tax through gradual marginal tax rates which depend on the income level. The system includes the personal allowance. The second (indirect) concept keeps progressivity through average personal income tax rate, despite the elimination of gradual marginal tax rates. Therefore, individuals would still need to pay different amounts, which depend on the income. Also, increased personal allowance mostly affects lower incomes because of higher non-taxable income. Therefore, flat tax system keeps indirect progressivity inside its proportionality.
Progressive tax systems aim to combine tax policy with social policy goals, which requires the introduction of various exemptions and deductions, including different marginal tax rates. On the other side, the flat tax system, or at least more simple tax system, aims to be neutral and reduces costs of tax administration. In this case, social policy would be a consequence of efficient tax revenue collection, in order to cover the needs for welfare expenditures. Therefore, even with the flat tax, governments could perform different social policies through direct social transfers, while the tax system would remain neutral.
SIMPLE, FAIR AND EFFICIENT TAXATION
Tax reforms usually aim to simplify the system, while at the same time tax administration increases efficiency in tax revenues collection. First, the flat tax reduces administrative and calculation costs, because several tax rates are displaced by a single one, while deductions and exemptions are abolished. Therefore, this reform process also simplifies tax forms into a form of a postcard, instead of having several papers.
The central feature of the flat tax is simplicity. Complicated tax systems require expensive tax advisers and audits. Both income taxes would be equal, having tax forms of a postcard. Income should be taxed only once, as close to its source. The firm would pay tax on sales revenues, except income paid to its workers (taxed as personal income), and all purchases of inputs from other firms, as well as purchases of capital equipment, buildings and plants, which represents an investment inventive. Furthermore, the business tax would not have deductions for any type of payment to business owners. As a result, all income would be taxed, including capital gains, dividends and interests. Concerning the individual income, pension contributions would not be counted as a part of wages and taxed. In other words, pension income would be taxed when the retired worker receives the pension (Hall and Rabushka, 1996). The idea of the business tax is to collect tax revenues from business income of its owners (Hall and Rabushka, 1995).
Simple, neutral and efficient taxation is favourable, with broader tax base, and abolishment of all deductions and exemptions, including better tax administration. However, tax system is not the most important for attracting investments and growth, but the reduction of overall tax burden and government’s role in economy. Investors mostly value political and institutional stability, and they also invest in countries with higher tax burden (Ott, 2005). Therefore, the tax reform which aims to reduce the tax burden and simplify the tax system is important, especially for countries with high burden and complexity of its tax system. However, other institutional factors need to be improved through structural reforms in order to create a sound investment climate. Although the flat tax can influence higher growth rates, a country may have other (non-fiscal) advantages which could attract investors, such as technological innovations and highly educated labour force. This may not be understood as the argument against the flat tax, but rather as a clear perspective that the flat tax can be considered only as one of several competitive advantages that could contribute to the economic growth.
The flat tax includes a single flat rate, which reduces penalties against productive behaviour, such as hard work and entrepreneurship. Moreover, the flat tax means the elimination of special preferences, reducing deductions and exemptions. Furthermore, the flat tax does not tolerate double taxation of dividends, capital gain, wealth, saving and/or death. The flat tax system requires only territorial taxation, when a government can tax only incomes earned inside national borders (Mitchell, 2008). The advantages of the flat tax are its simplicity and transparency, cost efficiency of tax administration, fairness and non-discrimination through equal treatment of taxpayers, without the existence of tax privileges, which ends political partiality (Srdoč and Anand Samy, 2005). The tax reform needs to include simplicity, incentives for capital formation and economic efficiency (Hall, 2004).
Any serious income tax reform must broaden the tax base and reduce high top marginal rates, making evasion uneconomic and undesirable (Hall and Rabushka, 1985). Supply-side tax policy stands for lower marginal tax rates because they stimulate economic growth and increase of tax revenues (Dorn, 1985). The main advantage of flat tax is stimulation of productive activities through hard work and entrepreneurship, which brings more income to individuals and companies. Therefore, accumulation of capital can be invested in new economic activities, including job creation. Higher business income and employment increase the amount of taxable money, so tax revenues can rise.
Seeing from the perspective of neoclassical theory, tax policy is highly effective in changing the level of timing of investment expenditures. Firms behave as to maximize profits. The marginal capital product should equal the rental value of capital input, which depends on the tax policy. The change in capital stock influences investment (Hall and Jorgenson, 1967).
Consumption taxes are related to consumption, not to annual income savings, so rich and poor people both need to pay it equally. This means that the VAT does not have any kind of progressivity in comparison with the personal income tax. Moreover, Reduced VAT rates on certain products do not guarantee lower prices, because prices depend on demand. Reduced VAT rates on certain products benefit not only poor but also rich people. Moreover, reduced VAT rates result in less tax revenues, so governments can increase the standard rate which results in dissatisfaction because it is related to the majority of products (Kesner-Škreb, 1999). VAT is a consumption tax which highly contributes overall tax revenues. Therefore, its administrative collection is very important for sound public finances and the tax base should be as broader as possible. The flat VAT rate would equally treat consumptions of all products and services, ending all special treatments.
One of the purposes of the flat tax on personal income is to reduce higher tax burden for higher incomes. However, in many countries social security contributions have even bigger influence on total labour costs and competitiveness. Therefore, the tax wedge, as the difference between before-tax and after-tax wage, depends on both personal income tax, including local surtax, and social security contributions, mostly for pension and health insurance. High social security contributions can reduce employers’ opportunities to hire more workers, making labour more expensive and therefore less competitive. However, reducing the tax wedge requires expenditure cuts in the budget. This would require cost rationalisations of social security systems, including the possibility of partial privatisation.
The size of labour supply, influenced by the tax policy, determines the labour force competitiveness. Reduced labour supply increases business costs and decreases productivity (Urban, 2009). If the tax burden is focused on employees, it has negative effects on net wages. If social security contributions put burden on employers, this can have negative impacts on labour demand because of high labour costs (Blažić, 2006). Higher employers’ contributions can result in lower net wages. As marginal labour costs equal marginal labour productivity, firms will employ additional employees if marginal labour costs are lower than the value productivity (Urban, 2009).
The reason for a high unemployment rate and low labour market participation can be found in high tax wedge. This correlation is strong, although not necessarily in each case, because there are countries with high tax wedge and low unemployment rate. Institutional factors need to be included, particularly the level of labour market flexibility, measured by the employment protection level (Grdović Gnip and Tomić, 2009). Therefore, countries with relatively high tax wedge and relatively rigid labour market, especially in combination with other institutional weaknesses, may be confronted with the probability of high unemployment. These problems should be considered as some of the potential causes of unemployment, although the whole framework of different institutional causes always need to be taken into account, in order to have a comprehensive picture.
ESTONIAN FLAT TAX REFORM
After a long period of Soviet-style communist system which led to massive repression organized against all spheres of human liberty, Estonia did not have any other chance than changing the whole society, including political and economic system. Prime Minister Mart Laar was aware of serious and deep reform challenges. Estonia expressed its strong decisiveness for the implementation of free-market policies, including the tax reform. In 1994 Estonia became the first country in Eastern Europe that introduced the flat tax system. In the meantime, the majority European countries soon followed its example. Estonia replaced progressive personal income tax rates (16, 24 and 33%, and 50% for a short period) with a proportional 26% rate, which was further reduced to 21% in 2008.
Vanasaun (2006) argues that the new system introduced broader tax base, easier tax administration and transparency, but it kept several tax incentives. Although the reform has been considered as flat tax, it is not precisely in its pure form (Saavedra, 2007), because tax exemptions in Estonia still apply on certain types of personal income such as capital gains, scholarships, fringe benefits, accommodation reimbursements for business trips, compensation for the use of private vehicles, child allowances, inheritance and gifts. Foreign diplomatic and consular representatives, representatives of international or intergovernmental organisations who are not citizens or permanent inhabitants of Estonia are not subject to personal income taxation (Ministry of Finance of the Republic of Estonia, 2009). The amount of basic personal allowance increased (Estonian Tax and Customs Board, 2009). Despite these exemptions, the tax system remained simple. Pre-filled by the tax administration, many tax returns in Estonia are submitted via internet (Vanasaun, 2006), which was a part of overall introduction of e-government services.
Government figures show that flat tax reform in Estonia had positive effects on tax revenues. Table 1 shows that tax revenue collection of both personal and corporate income tax increased almost each year, including VAT revenues. Corporate income tax revenues decreased in 1996 and then in 2000-2002, because reinvested profits became tax free. Personal income tax revenues increased each year except in 2005 and 2008, while VAT revenues decrease only in 1998 and 2008. Table 2 shows that tax revenues in 1996-2007 increased.
Table 1 – Estonia: State budget tax revenues (1995-1997); in thousands EEK
|Budgetaryyear||Personalincome tax||Corporate income tax||Value addedtax|
Source: Ministry of Finance of the Republic of Estonia (2010)
Table 2 – Estonia: Overall general government tax revenues (1996–2007)
yearOverall tax revenues
(in millions EEK)199620,332199728,902199828,138199927,830200032,786200136,666200242,786200348,413200455,123200564,407200679,184200794,714
Source: Bank of Estonia (2010)
In 2000 Estonia enacted an innovative corporate tax reform. While redistributed profits were kept taxable, reinvested profits became tax free. Capital gains remained untaxed if the receiver is an incorporated Estonian firm, while natural persons needed to pay 26% on their capital gains. In the following period, corporate income tax rates were cut from 26% to 24% in 2005, 23% in 2006 and 20% in 2007. Dynamic effect of the Laffer curve has been shown in Estonian case because tax cuts resulted in higher tax revenues due to more investments, production and taxable income (Arrak, 2008). Angelov adds that Estonian corporate income tax rates have been applied to all redistributed profit, irrespective of dividends, gifts, donations, representations, non-business expenses and payments, or fringe benefits.
After hard annual economic downturns in first years of transition followed by the collapse of Soviet-style communist system, in 1995 Estonia started to grow continuously each year, except in 1999. Table 3 shows that the Estonian economy already in 1997 reached high 11.7% real GDP growth rate, followed by annual growth rates at least or even higher than 7.5% since 2000. In 2000 the unemployment rate reached record 13.6%, with annual decreased to 4.7% in 2007. In 1999-2004, FDI inflow almost tripled, including net investments. While in 1995-2000 average annual real GDP growth rate was 5.3%, Estonian GDP rapidly increased reaching its average increase of 8.4 % in 2000-2007 (Bank of Estonia, 2010). Angelov adds that within the same period, reinvested profits increased more than 12 times, from 46.1 to 573 million euro.
Table 3 – Estonia: Annual real GDP growth rates (1995–2007)
|Year||Real GDP growth rates (%)|
Source: Bank of Estonia (2010)
Rapid privatisations and organisational restructuring, flexible labour market policies, balanced budgetary policies, flat tax system, with no taxation of reinvested profits, e-government public services and other free-market reforms have contributed to these Estonian successes, beside other factors. Estonian economic model attracted confidence of foreign investors through massive capital inflow. There cannot be a simple conclusion that the flat tax itself has attracted foreign investments and economic growth in Estonia. Estonia tax reform and tax cuts have contributed these economic policy achievements, together with other important structural free-market reforms.
SLOVAK FLAT TAX REFORM
Flat tax reform in Slovakia was introduced in 2004 by a centre-right government, led by Prime Minister Mikulaš Dzurinda and Deputy Prime Minister Ivan Mikloš. Slovakia decided to implement a set of free-market reforms in order to stimulate investments and growth, after years of lagging behind other countries of Central Eastern Europe. Structural reforms were adopted in the field of the labour market, fiscal system, pensions, health care, education and business environment.
Taxes started to be understood as an economic burden rather than active tools of economic policy. Therefore, tax reform was one of the most important initiatives for competitive and non-distortive market environment. Its goal was to transform the Slovak tax system and increase its competitiveness through efficiency and transparency. Simplification of the tax code improved business environment. Also, the Slovak tax reform was followed by two important projects: e-DP (Internet input of tax declarations) and e-TAX (Ministry of Finance of the Slovak Republic, 2005).
Mikloš (2005) argues that the power of Slovakian tax system derives from its efficiency and transparency. Like in other countries, previous tax code was complex with various taxes, rates, deductions and exemptions. So the tax system produced administrative costs and difficulties to small and medium enterprises, while others, especially big and influential businesses, were able to find legal ways to evade taxation (Srdoč and Anand Samy, 2005).
Three main goals of Slovak tax reform were suitable business and investment climate for individuals and companies, removing the existing weaknesses and distortions and fair reform focused on equal taxation of all sorts and amounts of income. The tax reform goals were achieved by shifting the tax burden from direct towards indirect taxes, because high direct taxes were distortive to fiscal competitiveness. Furthermore, all exceptions, exemptions and special regimes were eliminated, while the flat personal income tax rate was introduced in order to increase labour productivity. Moreover, tax instruments aimed at achieving non-fiscal goals were eliminated, as well as double taxation of income (Goliaš, 2005).
The aim of the tax reform was to tax all types of income at the same manner, regardless of the economic activity, in order to increase potential economic product. Tax reform introduced a uniform 19% flat tax rate on personal and corporate income and VAT, which removed multiple tax rates that existed before. Personal allowance was increased. Personal income deductions were kept for taxpayers with non-working spouses (Krajčir and Odor, 2005), pensions and charitable contributions (Basham and Mitchell, 2008). Therefore, it is precisely not a flat tax in its pure form (Saavedra, 2007). Taxation of dividends, inheritance, gifts and real estate was abolished (Oravec, 2008). The aim of the tax reform was to shift the tax burden from income (direct taxes) towards consumption (indirect taxation). This way the system penalizes consumption which reduces savings needed for capital accumulation rather than income which is a result of productive business activities. Second, a single rate makes the system neutral, fair, transparent and more attractive for investments and job creation. Third, the new system manifests the need that taxes must affect everybody, including groups targeted by social policy tax exemptions.
Slovakia also reduced its social security contributions from 51 to 48% (Gallagher and Babić, 2006). Various sorts of contributions put 13.4% burden on employees and 35.2% on employers (KPMG, 2009). It is important to notice that social security rates have been high in Slovakia, which represents the main source of fiscal burden on labour competitiveness. It can be concluded that the introduction of flat taxes may not be sufficient without taking into account the whole perspective of fiscal burden on labour. As in other continental European countries, social security contributions represent important budgetary revenues need for financing health care and pension expenditures. Therefore, cuts on that fiscal field directly depend on health care and pension system restructuring, especially rationalisation of costs and increased organisational efficiency. Government figures show that the flat tax reform in 2004 had positive effects on all tax revenues, which were increased each year. This may be a result of broader tax base due to increased economic activities through higher investments and employment and decreased grey economy.
Table 3 – Slovak tax revenues (2000–2007), in thousands EUR
|Corporate income tax||Value added
Source: Ministry of Finance of the Slovak Republic (2009)
Flat tax reform had positive effects on economic growth. Two years before the reform real GDP growth rates were 4.8%, while they increase after to 5.2% in 2004, 6.6 to 2005, 8.5% in 2006 and record high 10.4% in 2007. At the same time, unemployment rates were decreased from 18.2% in 2004 to 11.1% in 2007 (Oravec, 2008).
Flat tax reforms in Estonia and Slovakia have created simple, fair and neutral tax systems, with positive effects on tax revenues, inflow of foreign investments and economic growth in general. However, these effects need to be seen from the comprehensive set of different free market reforms implemented in Estonia and Slovakia, including the flat tax reforms. Therefore, flat tax policies are desirable for improving business climate in order to create transparent and neutral tax systems, with incentives for savings and investments.
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 Average personal income tax rate means the amount of personal income tax divided by the tax base (taxable and non-taxable income).
 Richard Sulík was a special adviser of Finance Minister Ivan Mikloš, who worked on the flat tax reform.
 Before the tax reform in 2004, Slovak income tax rates were 10, 20, 28, 35 and 38 % for individuals, 25, 15 and 18% for businesses. Standard VAT rate was 20% and a reduced rate was 14%. In 1993 Slovakia had six progressive personal income tax rates between 15and 47%.