Get Ready for the Flat Tax Debate

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.

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.

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.

Supporters counter with a familiar pair of arguments - less tax evasion and higher growth. Even if flat taxes helped curb tax evasion in Eastern Europe, there is no reason to think they would have the same effect in Western Europe or Australia. It assumes tax evasion on a scale nobody seriously believes happens in any western country. As to higher economic growth, supporters invoke the dubious Laffer Curve to suggest that the reform stimulates economic growth which eventually replaces the lost tax. David Walker wrote in The Guardian that even if true, “eventually is a long time in politics” and in the interim services would be slashed.

The alternative to slashing services is to raise other taxes, which is what some East European countries are doing. Romania is currently raising VAT and excise to plug the gaps in revenue. Other countries now have specific social security payments, of up to a third of income, on top of the flat income tax, so the amount of tax taken from salaries is not as low as the headlines suggest. Taken together, these make you wonder how beneficial their flat taxes really are.

Proponents argue that current systems are extremely complicated and difficult for ordinary people to understand. A modern economy is made up of people earning or acquiring money in an enormous range of ways, from an enormous range of sources and doing an enormous range of things with that money. There are also huge differences in the total amount of income people have. The complexity of the tax system is what makes it relatively fair and simplifying it will not necessarily make it fairer. We have accountants and tax specialists to navigate the tax system, in much the same way that we have solicitors for the law, doctors for medicine and mechanics for cars. No one argues that it would be better or possible to simplify the law, medical principles and cars to the point where anyone could be an expert.

To make flat taxes more palatable, proponents argue that they will benefit those on low incomes. This is a smoke and mirrors exercise. The poor benefit from generous thresholds, but this actually makes it a two tier system - a lower rate of 0% and an upper rate of X%. This benefits the poor only because it removes the “flat” element. A progressive tax system could equally well have a generous threshold.

Flat taxes also are not flat because, despite claims that the system does away with the need for exemptions and complexity, these survive. Under the models being pushed in Western countries share dividends, interest, rental income and some other taxes are variously made exempt, despite clearly being income - unsurprisingly this would mainly benefit the rich. Similarly the tax system is currently used to encourage behaviour which is seen as good, either for us or for others. So superannuation contributions and charity donations need to be treated differently. Furthermore, the elderly are also suggested as a special group requiring different treatment. This is just the start of the list, and it is making a simple flat tax look decidedly complicated and not very flat.

The only way flat taxes can be made to “work” is through cuts to services or increases in other taxes, as well as modifications that mean they are fundamentally not flat - such as thresholds and exemptions. It is hard to escape the fact that they are promoted by those who also push for fewer public services, increased incomes for the wealthy and a smaller role for government. The flat tax concept is simply window dressing for good old-fashioned greed.

The flat tax debate will arrive here. John Howard has successfully promoted two ideas about personal taxation. One is that the top rate of income tax should match the corporate tax rate. The other is that personal taxation needs to be “internationally competitive” i.e. the top rate should be lower. This provides fertile ground for flat tax supporters.

Being internationally competitive depends on a range of factors, including investment in R&D, infrastructure, education and ICT - all of which are currently below standard. Income tax is peripheral as most people are not willing or able to move around the globe chasing a few cents in the dollar. Besides, there is still plenty of scope for adjusting rates and bands within a progressive system, as contributions from Craig Emerson, Bill Shorten, Steve Bracks, Peter Costello and others demonstrate.

Australia’s economy is broadly in good shape and does not need the kind of boost for which flat tax supporters argue. But then, Britain’s economy is equally sound and the debate has now reached the political mainstream there.

Ultimately a flat tax could not work in Australia, but that does not mean the debate won’t happen. Australia is a modern economy with good public services and low levels of tax evasion. A flat tax would lead to a huge drop in tax receipts, which may or may not “eventually” be regained through higher economic growth. In the interim, the loss of revenue would need to be offset by swingeing cuts to the services Australians rely on and value dearly. Alternatively, services could be maintained if a flat tax was set at a level which left total receipts where they are. Whilst this would benefit high and low income earners, it would torpedo the finances of those on middle incomes - the very people everyone is currently so keen to help.