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Last Updated: Friday, 7 January, 2005, 19:19 GMT
East Europeans opt for flat-rate tax
By Gabriel Partos
BBC South-East Europe analyst

Bucharest street scene
Romanians are coming to terms with a new flat-rate tax system

Romania's uniform income tax rate is the flagship economic policy measure of the country's new centrist government.

Set at 16%, its implementation at the beginning of the year follows similar moves in a number of ex-communist countries in the region.

The renaissance of the flat-rate income tax was pioneered by Estonia, which has been in the vanguard of free-market reforms since it regained its independence from the Soviet Union in 1991.

Estonia's introduction of a single rate of income tax in 1994 was quickly followed by its Baltic neighbours, Latvia and Lithuania.

Historic irony

What looked initially like a scheme espoused exclusively by small transition economies moved onto the centre stage of economic policy when Russia's President Vladimir Putin introduced it in 2001, at an exceptionally low rate of 13%.

Since then the flat-rate tax has been adopted in Serbia, Ukraine, Slovakia, Georgia, and now in Romania.

Because it offers a lower rate of taxation, the flat tax reduces the incentive for tax evasion
Andrei Grecu, economist

There is a certain irony to the growing popularity of the uniform rate of income tax in countries that were previously run by communist parties.

It was Karl Marx who, in his Communist Manifesto of 1848, was among the first to call for "a heavy progressive or graduated income tax," at a time when across the early industrialising countries the flat rate was the norm.

Subsequently, as capitalist societies became more prosperous, they adopted Marx's demand and introduced higher rates of tax on higher bands of income to finance improved social welfare measures.

Since then it has become the orthodoxy - though one that has been challenged over the past quarter of a century.

Fewer tax dodgers

That challenge began in the US under President Ronald Reagan and in Britain under Prime Minister Margaret Thatcher in the early 1980s. It involved both reducing the number of tax bands and the rates at which tax was being levied.

Bratislava street scene
Slovakia adopted radical economic reforms and growth has soared
However, to date no Western country has introduced a flat-rate income tax.

Romanian economist Andrei Grecu, who recently published a paper for the London-based think-tank the Adam Smith Institute, advocates a flat-rate tax for Britain.

"Because it offers a lower rate of taxation, the flat tax reduces the incentive for tax evasion. People are more willing to pay the correct tax burden when the tax is lower," he says.

"In Spain about one-fifth of the economy is the black economy, and they are thinking of implementing the flat tax to bring this part out in the open and tax it."

'Little effect'

Apart from reducing tax evasion, advocates of the flat-rate tax argue that it both encourages the unemployed back into work and those already in employment to work harder.

But research conducted in Russia by the Institute of Fiscal Policy has come up with different findings. One of those involved in that research was German economist Alexander Klemm.

"There was some improvement in tax compliance and absolutely no effect on labour supply or work effort," he says.

"Overall the tax reform was certainly not paying for itself, in the sense that cutting tax rates has not led to higher tax revenues."

In any case, a single tax rate set at a relatively high level - in Estonia it was initially fixed at 26% - may not be enough of an incentive. So its success seems inherently linked to lowering the tax rate.

Radical vision

"The idea of a flat tax is to bring the rate a little bit lower than the highest or even the average rate and to encourage economic activity. If you increase economic activity, it brings more revenue to the government," says Mr Grecu.

The most radical versions of flat-rate taxation see a single rate not just for income tax but also for corporation tax, as is the case in the new system in Romania.

They also want to eliminate what they see as double taxation. In other words, if a company has already paid corporation tax, they believe that those who invested in it should not have to pay tax on their dividends.

But in the West, the flat-rate tax has not made much progress beyond a circle of free-market economists.

"Income tax is usually the most efficient method of redistributing income from the better-off to the less well-off, and by having a flat-rate tax you limit this very much," says Mr Klemm.

Meanwhile, the main opposition parties in both Poland and the Czech Republic favour the introduction of a flat-rate tax.

If these two countries were to follow their eastern and southern neighbours in the coming years and prove a success, advocates believe it may also encourage Western governments to reconsider the arguments for flat-rate taxation.

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